The Fed’s Action – A Total Eclipse

Economic analysis by Filipe R. Costa

Britain woke up today with its skies darkened by the first big solar eclipse in 16 years. So much time has elapsed since the last one that taking a few minutes to watch the rare event is a must. But to maximise amusement one should be closer to the North, on the Faroe Islands or in Norway where the eclipse is total. In my case, I was in Portugal, in the foggy city of Oporto, which unfortunately scuppered my plans of getting the most out of the event.

Now that the moon is gone and the sun preparing to shine again (hopefully!), it is time to revert to the financial markets and monetary policy action, where the eclipse seems to be more persistent, as Janet Yellen and the Fed are unable to make up their minds on the route monetary policy should follow.

Since the end of QE3 at mid-2014, the Fed has seemed lost without any idea of what to do or when to do it regarding interest rates. With interest rates already near zero for years, the Fed’s balance sheet above $4 trillion, the unemployment rate down to a decent 5.5% level, and the economy growing (even if just at a moderate rate), there is no theoretical justification to not raise interest rates immediately. But the Fed seems too hesitant, tweaking words from statement to statement; now being patient, then being not in a hurry; now applauding the economic recovery, then downgrading it to just moderate; now ignoring the international picture, then weighting its risks.

At times when the interest rates nears the zero lower bound, the “non-standard” measures of monetary policy gain relevance. One of those is the central bank communications, through statements and press conferences, which can help to shape public expectations of future policy actions. But when looking at the latest Fed statements and press releases, what I discern from them is a major hesitation, which can only translate into uncertainty and volatility for the financial markets. Ultimately the Fed is just contributing to higher volatility, with the EUR/USD reaction to the latest Fed statement being clear proof of it. In a matter of just a few hours the pair rose from below 1.06 to above 1.10, just to reverse the trend overnight.

The Fed is too concerned with the initial reaction the public may have to the eventual hike in interest rates. But they shouldn’t be. Most of the initial reaction comes from high frequency trading and computer-driven trading just trying to speculate on the Fed’s wording while gaining some first-mover advantage over the public. But this overreaction will just fade overnight. The Fed should disregard it and instead concentrate on the economic fundamentals, which now point towards mild inflation (no deflation whatsoever), moderate growth, and low unemployment. Such a scenario requires rates much higher than zero.

Neither should the Fed concentrate too much on inflation being below target, but rather on avoiding transmitting erroneous information to investors. At a time rates should be around 2%, projects are being approved at near zero discount rates. The Fed is running the risk that many investments are being made based on an unrealistic discount rate. When the rate starts catching up with reality those projects will end up being liquidated and will be the basis for the next crisis. The longer the Fed takes to hike rates, the larger this problem will become.

By the same token, the Fed’s dovishness and hesitance is giving the wrong message to emerging markets and allowing them to cut interest rates and become heavily indebted in dollar terms. A delay in rate increases allows these countries to pursue accommodative policies that may end in a huge currency crisis in the near future.