A game of chicken: The Fed lost

Week ending Friday 17th March 2017

Last week we called it a “A Game of Chicken”. We wondered who would blink first. Well, we know now. The Fed blinked. Having cranked up expectations for tightening two weeks previously they did the bare minimum. Just 25bps rate rise, but no change to projections, disposal of Fed assets or anything else.

The markets heaved a huge sigh of relief and effectively said it was relative monetary easing. “Relative” because money remains tight, just a bit less tight than it was.

The Fed wants it to rain but no one to get wet

Did the Fed want this market reaction? We said that the Fed wouldn’t be happy with the market reaction and would be emboldened to push on further. Good (economic) news would be bad news for markets and bad (economic) news would be bad news too.

Strangely enough this is exactly what the far better informed Goldman Sachs suggested was the Fed’s view, too. They appeared to have made a mistake. They wanted the market to raise rate expectations, not drop them.

But the Fed seems to want to keep economic expectations up, too. Well you can’t have it both ways,    Janet. You can’t get rates up without an economic recovery, and you can’t have an economic recovery by tightening monetary policy. Looser monetary policy brings on an economic recovery and brings on higher rates. That is the direction of causation.

The Fed wants to make it rain with tighter monetary policy leading to (it thinks) higher rates but for no one to get wet as the economy sails on happily.

Markets say economy is OK, but not great

The message the market is giving is that the economy is just not that strong. Macroeconomic Advisers even found negative nominal MoM growth in GDP in January and the Atlanta Fed GDPNowcast is forecasting just 0.9% annualized RGDP growth in Q1. Admittedly, the NY Fed is still expecting 2.8% RGDP growth but this is well ahead of a declining consensus. Our market-influenced NGDP Forecast is still at near terms highs for YoY growth in 2018Q1 at just over 4%. The last forecast for 2017Q1 was set for nominal growth of 3.5%. We are at 4% because markets still have confidence in Trump’s supply-side reforms plus a belief that the Fed won’t get it to rain on the parade.

The downbeat economic forecasts are somewhat at odds with all the confidence levels that are at highs, especially for future expectations. Some surveys do indicate caution on current conditions, but not the majority. It seems that nominal growth is looking stronger as evidenced by headline retail sales moving above 5% YoY, but this is partly due to headline CPI and PCEPI picking up. Real growth is less obvious. In addition, we think the pickup in headline inflation will not last. It may also be due to some odd seasonal adjustments as the chart shows non-seasonally adjusted headline retail sales growth dropping strongly YoY in February.

A contrast of two central banks

The UK central bank has performed admirably well since immediately before Brexit. Despite entering the political fray with strong views on the potential economic damage, the market realised that the message from Governor Carney was that the Bank of England would ease monetary policy if the vote went to Leave. The GBP duly fell after the vote and then fell some more when the monetary easing plan became more explicit – involving more QE and, crucially, a commitment to tolerate above target inflation in the medium term. This truly and formally flexible inflation target went down very well and NGDP duly recovered from its lows of 2015 and early 2016.

Somewhat unsettled by the economic robustness, and its success, the Bank of England signalled it could pull back on the toleration at some point. The Monetary Policy Committee did not raise rates last week but it did tighten by its statement and the GBP duly rose.

“With inflation rising sharply, and only mixed evidence on slowing activity domestically, some members noted that it would take relatively little further upside news on the prospects for activity or inflation for them to consider that a more immediate reduction in policy support might be warranted …”

Its “hawkish hold” contrasted with the “dovish hike” of the Fed. The Bank of England has credibility and knows what it is doing. The Fed has less credibility and will have to “correct” the market.

Don’t fight the Fed

This correcting of the market by the Fed will come over the next few days and weeks in speeches and interviews by members of the FOMC. Watch this space and beware.

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