Highlights:
- Despite a Committee composition that is decidedly more dovish than that of last year, the FOMC made a few changes that give the Fed a good deal more flexibility in their timing for rate normalization lift-off. Using words such as solid growth and strong employment gains would allow the Fed to continue down previously telegraphed mid-year (June) lift-off, but recognizing the near-term softness in inflation, combined with referencing international conditions, provides the central bank with the ability to wait until September to begin the lift-off process.
- Part of what may provide assurance to Committee members is the fact that global monetary policy has continued to ease quite dramatically, providing a window of opportunity for the Fed to begin normalizing rates.
- It’s also vital to understand that revolutionary technological advances are changing longstanding economic relationships regarding inflation and employment, so both policy makers (and investors) may be using outdated playbooks today for properly judging the economy.
Extended Overview:
Without question, this is a very challenging time to be a U.S. central banker considering policy change. Indeed, the views expressed in yesterday’s Federal Open Market Committee (FOMC) policy statement, the first of 2015, appear as an attempt to strike a balance between the impulse to recognize the strengths of the U.S. economy and begin to normalize interest rates, and concern over the possibility that slowing global growth could eventually hurt our own economy. For example, the statement specifically mentions “international developments” as a factor the Committee will take into account, but it also upgrades its characterization of economic growth to “solid” from the previous “moderate,” and jobs growth to “strong” from the previous “solid.” The Committee also recognized the tailwind to the consumer represented by lower oil prices, and updated its language on inflation, suggesting recent moves lower are “largely reflecting declines in energy prices.” Overall, the tone of the statement, and the lack of dramatic change since December suggests to us that the Fed is still likely looking to June for the base-case timing on policy rate “lift off.”
Additionally, the shifting composition of the Committee’s membership complicates both its own decision making, as well as market participants’ interpretations of those decisions. To briefly review, the new members on the committee (Dennis Lockhart and Charles Evans) have been extremely dovish in their public comments on policy, while they are replacing very publicly hawkish former Committee members (Charles Plosser and Richard Fisher). And while Narayana Kocherlakota, a highly dovish voice at the Fed, also departed the Committee membership in 2015, the upshot is that there has been a significant shift in Committee membership toward a more structurally dovish stance. While that suggests that this Fed is likely to hold a bent towards greater “patience” in maintaining its easy money posture, this was not broadly reflected in yesterday’s statement.
At the same time, we are witnessing historic moves in expanding global regimes of quantitative easing by the European Central Bank and the Bank of Japan. Indeed, the ECB announced a dramatic expansion to its QE program, such that it will start purchasing €50 billion in European sovereign debt each month (bringing total purchases to €60 billion/month, including the current asset-backed and covered-bond purchase programs). These purchases are expected to be conducted at least through September 2016 (a €1.1trillion increase in the central bank’s balance sheet), but ECB President Draghi suggested that the program is designed to be open-ended, similar in effect to the Fed’s QE3 program, so the ultimate amount of monetary expansion may be greater. Additionally, we have also seen many other central banks take accommodative actions in recent weeks, such as those in Canada, Switzerland, Denmark, India, Turkey, and most recently, Singapore. The cumulative impact of these policy moves is to effectively render the U.S. rate structure as “high” relative to the rest of the world, thereby forcing the USD even higher vs. the currencies of other “excessively easy policy” central banks.
We have argued in the past that dollar strength should not place the U.S. economic recovery at risk (Institutional Investor, November 21, 2014), and we still believe that to be the case, however, clearly a stronger dollar is having an impact on export conditions and currency competitiveness, and presents an earnings headwind for some companies. The Fed is keeping a close eye on that development. Yet, we would argue that the Fed’s excessively easy policy has to be moderated, even with the near-term currency headwind that may reduce earnings for some companies. In fact, in our view the costs (and risks) associated with continuing excessively easy policy- in an economy that despite coming off the boil recently is nevertheless growing near its strongest rate in decades- are simply too great. We are clearly close to full employment in the U.S., inflation is benign today, and should head higher alongside some wage growth, but the distortions to asset prices and capital allocation decision-making are likely underestimated by officials in an environment of general global policy excess.
The underestimation of systemic risk is a particularly easy trap for policy makers to fall prey to today, since in our view revolutionary technological advances are changing longstanding economic relationships regarding inflation and employment. That complicates the task of both policy maker and investor. Still, the influence of technology on the economy today is palpable, even if the Fed’s analysis of the aggregate economic data misses much of its force. In fact, to look at only one example we have recently explored elsewhere: the rise of online retailing, and the tremendous degree of price transparency it affords U.S. consumers, has had the natural economic consequence of reducing retailer pricing power, moderating inflation, and shifting employment away from traditional brick-and-mortar stores.
This dynamic holds monumental benefits for U.S. consumers, even as some corporations’ margins will compress, some workers will be displaced, and inflation will appear to be too low. Under this evolving economic paradigm, economic growth can take place with lower levels of inflation than those seen historically, and employment is changing in a multitude of ways too (from its industry mix, to the rise of just-in-time hiring). Monetary policy clearly has some influence on the economic trajectory today (primarily through the so-called “wealth effect” of asset price inflation), but in many respects it is also a bystander alongside much larger secular/structural changes to the economy.
Yet, excessive policy does hold the potential to do more damage than good by staying too easy for too long. Asset price distortions can create volatility, and today volatility is higher both based on the size of the distortions we are seeing, and the length of time that they are allowed to persist for. We have seen this movie before, and it does not end well. In its policy statement, the Fed has said it will be “patient,” and while often thought to be a virtue, we would suggest the central bank has already displayed a good deal of patience. The time perhaps has come to be patient in a different way, by allowing global currencies the time adjust to new economic realities, growth patterns, and trade arrangements. Yesterday’s statement suggests that the Fed continues on its path toward rate normalization by mid-year. However, the risks to a mid-year move have increased with the rise of myriad uncertainties internationally.
Rick Rieder, Chief Investment Officer of Fundamental Fixed Income, BlackRock
