Central Bank Watch: FOMC Minutes (And RBI)

| About: WisdomTree India (EPI)

It is highly interesting to see the views and counter-views on the impact of low rates on the DCF industry. I think both miss the subtle point here. All these DCFs and PVs and pretty much everything else depends on an assumption of properly functioning lending and borrowing market. The question is: if negative rate does persist for long, will that assumption break down or adapt?

Speaking of rates, the FOMC minutes released this week were very informative. It was a much more ambivalent FOMC than we have seen earlier. It appears the September "Hold" decision was a close call. So it is safe to assume it will be so in November and December (if there is no hike in November) as well.

On the major points that drives the "data-dependent" FOMC, it seems the consensus is on the labor markets. Since the last meetings, we have had more or less similar or slightly improved wage data. However, this week's job opening (JOLTS) was a bit disappointing. On economic growth expectation, retails sales data from Friday was more or less on the mark, matching street expectation, and capital goods has shown improvement from earlier as well. Even the much-discussed negative influence of foreign GDP has subsided. Eurozone forecasts edged up to 1.3% from 1.2%, and UK forecasts from 0.50% to 0.70% (since the September FOMC).

Surprisingly, however, on both of these parameters, the Fed's own measure is going the other way. The Labor Market Condition Index and the Atlanta Fed's GDP nowcasting have both nose-dived in recent readings.

On the inflation front, both the CPI and PCE have edged up since. The CPI is still suffering from an energy prices drag. Given the recent moves in oil prices, this should have a positive impact on data before the next meeting.

Overall, I expect the data to be neutral for both employment and growth and marginally hawkish for inflation for the November meeting. The possibility of a November hike is still lower. Partly, that will be a surprise for the markets - which currently prices in a 17% chance of a hike at November FOMC and a 64% at the December meeting. As I discussed before, Fed has never hiked before without a substantial chance priced in by the markets.

That said, one particular line of arguments stands out from the released minutes:

A few participants referred to historical episodes when the unemployment rate appeared to have fallen well below its estimated longer-run normal level. They observed that monetary tightening in those episodes typically had been followed by recession and a large increase in the unemployment rate. Several participants viewed this historical experience as relevant for the Committee's current decisionmaking and saw it as providing evidence that waiting too long to resume the process of policy firming could pose risks to the economic expansion, or noted that a significant increase in unemployment would have disproportionate effects on low-skilled workers and minority groups.

There were only two major hike cycles not followed by a rise in unemployment in recent history. One was following the early '80s recession, and the other following the early '90s recession.

This points towards a strong commitment of the FOMC towards a gradual rate hike, even if the initial hike has to be brought forward in time. It will be very surprising if we do not have another hike by the end of the year. But this, along with the now lower long-term equilibrium rates also means it will NOT be particularly threatening to US equities or rates in general (both slopes and levels). Fade the move if any respond violently to FOMC one way or the other.. Both equities and rates should depend less on FOMC and more on intrinsic and unexpected events.

Talking of unexpected events, one is, of course, the US presidential election. The general expectation is of a sell-off if Mr. Trump wins. Although I fail to see a rally even if it is Mrs. Clinton. And, of course, market expectation can be wrong. In 2012, it was widely expected that an Obama win will be bad for equities, and indeed, there was minor sell-off leading up to Election Day. However, the results marked the start of a long stretch of bull run.

October was also a historic moment for the Reserve bank of India. It saw a new governor (following the exit of Raghuram Rajan) and its first ever Monetary Policy Committee decision. And it was a decision quite difficult to understand - an (mostly) unexpected 25 bps cut. The RBI revised GDP higher and both real rate and inflation lower. A lower real rate expectation usually means a lower potential GDP. That means a higher GDP will lead to potential overheating. A lower inflation rate is not consistent with this, unless the RBI is expecting substantial imported disinflation.

India's decreasing credit growth is a worry, but it is not clear that higher rates are the culprit here. The decline is driven mostly by the industrial sector - which presumably has more on its plate than to worry about higher rates. And in any case, the pass-through of RBI rate cuts by the banking sector has not been exemplary in recent time, which has been mired in its own significant bad loan problems. It was appeasing to the markets (and politics, perhaps), but hard to imagine how much, if at all, it will help the economy forward.