Tip-Toeing Through The Policy Minefield

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Summary

Has the economy really shrugged off Brexit risk, as The Wall Street Journal says?

Or is Brexit still a worry — and grounds for forecast-cutting, as the IMF is doing?

Is the way really clear for rate hikes?

Is the Fed headed for disaster — one way or the other?

It's a wild, wacky world out there, and no one knows what the future holds. Recently, The Wall Street Journal's 'Fed experts,' Jon Hilsenrath and Michael Derby, wrote that the Fed is getting more certain of a rate hike this year. Meanwhile, the IMF has just cut its outlook for global growth, admittedly by the smallest margin possible. Still, it warns of uncertainty over Brexit.

I calculate that June's steep month-over-month drop in EU economic confidence in the wake of the Brexit vote has been exceeded in month-over-month calculations historically in just 10% of readings since 1990. The German Zew reading and the Swiss Zew readings on sentiment both have fallen sharply in the wake of the Brexit vote. UK confidence is lower, too. We could add to this list a drop in US consumer sentiment, as measured by the July preliminary University of Michigan index. None of these data points support the supposed position of Fed officials. Admittedly, retail sales and the jobs report perked up a bit, but there are still signs of slowing in the air and on trend.

Fed info

When it comes to the Fed, what we have to go on are these comments by WSJ insiders, and somewhat vague comments by Fed officials themselves that are very open to different interpretations and often are offered in a conditional format. But as we have seen in the past, Fed intentions do not always make their way to Fed policy. And Fed policymakers can change their tunes.

Fed actions Vs. Fed words

In September 2015 the Fed hiked rates, even though its own conditions for hiking were not met at the time. At various points in 2015, all Fed officials had voiced support for the belief that rates would finally be raised before the end of 2015.

In the end, in December 2015 — at the very last minute — the Fed did vote to lift the Federal Funds rate. But it did so as conditions changed. The Fed chose to hike rates after a rate hike hiatus in September adopted when the global economy became skittish. Still the Fed chose to hike rates and to assert that inflation was on a path for 2% despite the fact that oil prices had come unglued and continued to fall to super low levels as the Fed whistled past the grave yard with its off-in-left-field 'forecast' of normalcy in hand. This decision will tar Fed credibility for years to come.

The history and role of Fed forecasts

The Fed has a bad record of forecasting in this cycle in particular. Its members in their SEP framework have consistently and independently thought that the right Fed funds rate for the economic environment would be much higher than the rate that actually evolved. And so as the WSJ is reporting they are at it again, who can be surprised? There they go again.

Once burned, twice shy? Or just an error in timing?

Instead of learning from past mistakes, the Fed is doubling-down in their hole. Fed members are sure that they have got the timing wrong but the event right. It's time-or almost time- to hike rates they think…But what if the Fed is dead wrong?

What dead wrong does…

If you miss your exit on the freeway the safe move is to go on to the next exit turnaround and come back. If the Fed makes a wrong turn with monetary policy the 'next exit' may be a long ways away and missing the right exit may have more profound consequences than a little lost time. Fed policy transitioned at the last meeting from an economy-management/growth-modulation mode to a risk management mode. But if the economy is no longer considered to be at risk the Fed could go back to growth management. But growth management at a time when risks are still high may be dangerous. And the Fed's judgment about the state of the economic environment has not been good. The WSJ assertion that markets have settled down in the wake of the Brexit vote is not a very deep or robust finding. So stocks are back to a new high. We know how ephemeral that signal can be. In December of last year the Fed thought international markets had steadied from their September hiccup only to find that chaos ensued in the wake of its December rate hike. One problem for the Fed's rate hiking ways is that a Fed rate hike stirs the pot. Conditions change after the Fed hikes rates.

Starting over

If the Fed chooses to restart the rate hike process I suspect it will try to do so in a more cautious mode. But some members are not geared for caution. Some want rates up to 1% relatively quickly. This would make the Fed's communication task quite challenging. And poor communication has undone more than one Fed policy move in the past.

No central bank is an island

To make matters worse this time around the Fed is pondering a rate hike while the rest of the world has central banks with their pedal to the metal and with rates at or below zero for a broad class of bonds and notes internationally. Negative rates in the rest of the world are pushing flows of money into the US. That will affect how (and may even, 'if') Fed policy works. The Fed has 'full control' over the Fed funds rate but, after that, rate determination is up to markets. With international funds moving so freely, capital flows are going to have a big impact on US monetary policy. While the Fed may choose to hike the Fed funds rate, rates along the yield curve may still be pressured lower subverting the Fed's desire to raise rates. If that were to happen, what would the Fed do?

The $64 trillion question

Suppose that scenario unfolded, and the Fed chose to hike rates but the markets reacted by moving more funds from Europe and Japan into the US, pushing the dollar up and Treasury yields down. What would the Fed do? Would the lower rate structure convince the Fed that it needed to hike the Fed funds rate even more? Would the Fed try to counter the market effect by reducing the size of its balance sheet even a bit earlier than it previously planned? Would either of these reactions have much impact?

Extraordinary monetary methods, or trapped like a rat?

If these 'extraordinary' methods worked so well - just like conventional policy, as some assert - we would not be in the mess we are in today. So regardless of what central bankers say, they are scraping the bottom of the barrel for policy options. Fiddling with the balance sheet is not going to have much impact. Trying to hike the Fed funds rate more as markets push market yields down might even invent the yield curve - that is not a good idea either. The Fed simply may be handcuffed. It has a small margin between Fed funds and zero. It has an infinite ability to hike rates but there is the potential for distortions from policies abroad to interfere. Unless the real economy makes some very clear statements about its position and strength monetary policy may be trapped like a rat.

The active lever and its broad impact

The dollar, however, may still be an active level of policy. Fed rate hikes could still help to push it higher and to weaken the economy. In the event of a Fed tightening, policy may wind up working almost wholly through the exchange rate. That would mean that policy would work through the goods sector in the US and through widening the current account deficit were the Fed to move rates up in such an environment. It might also place a more substantial burden on the rest of the world as a stronger dollar would send a chill through global commodity prices. Monetary policy in such a world would have only an indirect impact on the U.S. services sector and rates would stay low to aid housing, a sector of only modest contributions to growth.

In the end risks are asymmetric

It is unclear to me that the economy in this environment could get strong enough to create any problems due to rates that could not rise. I do not see that the US economy has a need for much restraint. There already is a lot of natural restraint. In an environment in which the Fed hiked the Fed funds rate but could not get leverage on the yield curve I would not see the economy getting overly strong. While this scenario is anathema to the hawks and monetarists on the committee my fear is almost wholly focused on the risk of weakness and the inability of the Fed to provide much more stimulus, should the economy weaken... If the Fed began hiking rates and capital flows prevented term rates from rising, the economy would have to generate some very strong growth or clear inflation pressure before there would be any real risk. And in the event that such characteristics would evolve, in all likelihood markets would then begin to react pushing rates higher.

How things work in reality; ECB policy is not an issue

Rates are more likely to price themselves to the needs of the environment when those needs are clear. Rates are unlikely to ignore the needs of the environment and to be swamped by foreign incentives in that event. If growth began to over shoot and if inflation began to rise, conditions and market reactions would simply change to allow monetary policy to work. Foreign monetary policy would not dominate policy in the US. In short the only real risk to the monetary policy is on the downside not on the upside. Policy needs to remain in a financial-stability/risk-avoidance mode. Inflation is not a real risk and a 2% inflation pace is not a fait accompli. The Fed needs to keep its eye on the economy in front of it instead of on the fears it conjures based on dogma. The Fed needs to stop beating dead dogma.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.