Fed Proves It's Market Dependent

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By Valentin Schmid

The Federal Reserve (Fed) did not raise interest rates at a meeting on July 27, despite solid economic data.

"The labor market strengthened and… economic activity has been expanding at a moderate rate… Payrolls and other labor market indicators point to some increase [and] household spending has been growing strongly," the Federal Open Market Committee stated after its meeting in Washington.

This proves that the Fed's decisions are not dependent on economic data, as the central bank has claimed many times in the past, but rather are market dependent. The Fed initially planned to raise rates up to four times in 2016 if the economic data improved, after it first hiked interest rates by 25 basis points last December. And yet so far in 2016 nothing has happened.

"The exact timing when we will have the next rate increase will depend on the data," John Williams, the president of the San Francisco Fed said at the Council on Foreign Relations (NYSE:CFR) in May.

"The data dependent aspects of the Fed get reconstituted or left out in a parking lot somewhere and completely ignored. … Data dependence augurs for a move. Many don't believe they will move in September's and November's meeting," financial commentator Rick Santelli said on CNBC.

For example, the Citigroup economic surprise index, which compares how data releases compare to economists' prior expectations, had its biggest winning streak in history, rising for 21 days straight. All important data points the Fed likes to monitor have improved throughout the year. Unemployment hit a cyclical low of 4.7 percent in May. "My own view is that we are at full employment," said Williams.

Not enough for the Fed though, according to the Federal Open Market Committee statement: "Job gains were strong in June following weak growth in May. On balance, payrolls and other labor market indicators point to some increase in labor utilization in recent months."

Click to enlarge
(St. Louis Fed.)

Even inflation ticked up to 2.2 percent in June on an annualized basis, right at the Fed's target of 2 percent. But the Fed can choose which indicators it takes into consideration.

It states: "Market-based measures of inflation remain low." This means financial products like Treasury Inflation Protected Securities or the spread between longer and shorter dated securities have remained below the Fed's liking.

According to Santelli, everything else, from housing to leading purchasing indicators, has been on the rise throughout the year. Housing starts, for example, are up at 1.2 million annualized in June.

"The United States is in a position where we should have raised a long time ago," Kyle Bass, principal at Hayman Capital said in an interview with RealVisionTV.

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(St. Louis Fed)

So what is holding the Fed back? Some say it's financial markets, which have been volatile after the British referendum to exit the European Union. A sharp drop was followed by a swift decline after global central banks started floating the idea of a renewed stimulus. A July hike would spoil the current rally.

"The simple answer is that via a mix of over-communication, excessive short-term data dependence, and considerable market dependence, they have shunted market expectations one way and then the other, to the point where the Fed cannot right size market expectations quickly enough to hike rates, without doing even more damage to their credibility," Alan Ruskin, a macro strategist at Deutsche Bank told Marketwatch.

"The Fed since 2008 has pursued a policy of putting the cart of speculation in front of the horse of free enterprise," James Grant, publisher of Grant's Interest Rate Observer, said at the CFR in June.

China Crash

Kyle Bass thinks Fed monetary policy would be overwhelmed by a financial crisis in China. "What is going to absolutely overcome the U.S. position is how many bad loans China has made. That will overwhelm the U.S. monetary policy," he said.

The Fed had indirectly referenced volatility in the Chinese currency as a reason not to raise rates last September, which caused the delayed rate hike in December. It did again say that "this assessment will take into account … readings on financial and international developments."

The Chinese currency and capital outflows - the main reason for concern last year and early this year - have been reasonably stable, so even on that front, the Fed doesn't really have an excuse not to hike, unless they are too worried about the hidden China crisis potential.

Citigroup chief economist Willem Buiter believes China may have a financial crisis if the current debt problems aren't tackled. "They are going to have a financial crisis. It can be handled because 95 percent of the bad debt is yuan-denominated, but you have to be willing to do it, you have to be proactive," he told Epoch Times in a recent interview.

Outlook

Despite the inconsistencies, the Fed insists it will hike rates as the economy improves and that this will depend on incoming data.

"The Committee expects that economic conditions will evolve in a manner that will warrant only gradual increases in the federal funds rate. … The actual path of the federal funds rate will depend on the economic outlook as informed by incoming data," it states.

Paul Brodsky, chief strategist at Macro Allocation Inc., believes the Fed would actually like to hike rates.

"They want desperately to hike rates.… If you ask yourself that question, 'What's best for the banks here?', that's going to give you your answer. That's why the Fed wants to hike desperately. They can't because the markets are not letting them. But I think the first opportunity again, they will hike. Maybe in September," he told Epoch Times.

According to Brodsky, the wider the margin between what banks pay for funding and the rate at which banks lend out money determines bank profits, and that margin is higher than the interest rate. "[Banks] don't care if rates go higher at all. They would love it," he said.