The Fed Paves the Way to a Rate Hike

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In stark contrast to December, this time the bots returned a “not found” error after seeking for the “considerable time” keywords in yesterday’s FOMC statement. The Fed disappointed all those expecting to rip risk-free profits in nanoseconds, as the considerable changes in the statement confused the bots and investors. On one hand, investors were still celebrating European QE, but on the other, the language changes in the statement represent a decrease in dovishness that can’t be ignored. In the end the Dow lost almost 200 points. In my view, this statement finally opens the door for rate increases and marks the inflection point in monetary policy in the US. The market reacted negatively but equity prices are still not fully discounting the risks, with many investors still scheduling the first rate increase in 2016.

The statement issued yesterday by the FOMC was a major disappointment for financial markets because it clearly represents a decrease in the degree of dovishness that had been the norm in past statements. The committee recognises not only that the US economy is growing but also that the current deflationary pressures coming from the energy sector are just temporary with a limited effect on medium term inflation goals.

According to what the Taylor rule states about the recommended nominal interest rate set by a central bank, there are two major variables that should be observed: 1) the inflation rate, or the gap between the expected inflation and the inflation target; and 2) the growth rate, or the gap between the expected growth rate and potential growth (which alternatively may be seen as an unemployment gap). All rest held constant, the higher the inflation rate and the higher the growth rate (or the lower the unemployment rate), the higher the suggested interest rate, in order to cool the economy and alleviate any inflationary pressures.

While the FOMC doesn’t explicitly adopt any Taylor rule or even make any references to it, it expressly makes strong references to its key variables. Yesterday’s statement refers to the economic recovery as occurring at a “solid pace” from a “moderate pace” previously, while at the same time job gains are “strong” as opposed to “solid”. Ergo, the committee sees a solid recovery and a strong labour market instead of a moderate recovery and a solid labour market, which when translating to the Taylor rule means a higher output gap pressing for higher interest rates. In terms of inflation, the committee in fact recognises not only that inflation is low but also that it can go even lower. But, at the same time, it acknowledges disinflation as being the temporary result of lower energy prices, with mid-term inflation goals still not much affected. Translating this part into the Taylor rule means that the committee sees the inflation gap as being less negative than many believe it to be.

As I mentioned in an earlier article, published just after the FOMC’s December statement, the Taylor rule was, at that time, pointing towards a positive interest rate of 2.6%. If we consider a PCE price index of 1% and an unemployment rate of 5.6%, the Taylor rule would still point to an interest rate of 2.3%, which is much higher than the current 0% level. In 2003/04 when the unemployment rate and the PCE deflator were not much different from current levels, the Fed main rate was around 1% and I don’t see many good reasons to keep it much below that level now, in particular after so many years of unconventional measures and zero interest rates.

A major change in the statement, which in my view is the final clue pointing to action rather than inaction, is the complete removal of the “considerable time” commitment. Even though the committee still claims it “can be patient in beginning to normalise the stance of monetary policy”, it is no longer committed to it, thus opening the door for the first hike in interest rates. Bill Gross, from Janus Capital, has just commented that he expects the Fed to hike rates by 25 basis points this year. I wouldn’t be surprised with 50 basis points or more, even though international developments may weigh negatively here. When the Taylor rule turned negative in November 2008, it took just one month for Ben Bernanke to announce QE, and when it turned positive in December 2013, the end for QE was announced. Unlike the ECB, the FED has been acting fast and there’s no reason to expect it to do it differently now.

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