We have lived in an age of the non-denial denial; the non-bank bank; the non-responsive response. Maybe the time is just right for a Federal Reserve interest rate hike that's really not a rate hike.
The Federal Reserve Board leadership has been stressing the virtue of "transparency" regarding the factors it is considering as it approached the first increase in interest rates since 2006, potentially at it's mid-September meeting.
Transparency of intentions, however, becomes extremely difficult when the deliberations of the Fed Open Market Committee (which sets the rate) are explicitly data-dependent and the data is mixed! As a result, many of the Committee's voting members are left, as Jon Hilsenrath documented in the case of San Francisco Reserve Bank Governor John Williams, find themselves "on the fence" as to whether or when to start the increase process.
Such a posture wouldn't come as a surprise to those inclined to see economists (the profession of most Fed Board members and Governors) as a classic "on the one hand, on the other hand" kind of decision-makers. Politicians, too - and some might say the Fed has a few of those, too -- can be that way. Consider the old pejorative political nickname "Mugwumps": -- office-seekers whose "mugs" were perpetually on one side of the fence, while their "wumps" were on the other.
More importantly, however, this posture may be the natural result when the only data available are subject to multiple reasonable interpretations. So it is with the rate decision: even the markets themselves seen as confused as the Fed officials - the bond market has generally been reacting as though no increase should be undertaken just now even though most bond traders seem to think the Fed is already behind and may have missed its chance earlier in the summer to get off the dime.
At the same time bond prices have been showing few signs of an imminently-expected rate increase, the stock market has put itself through a dramatically quick downward correction for the first time in nearly four years. Some commentators considered this late-August move both a cry of pain that the Fed might soon move away from its famous stock market "put" (the zero interest rate policy underwriting and even encouraging a "risk-on" market) but also a cry to the Fed to simply "get it over with already" and end the uncertainty that traders abhor like nature hates a vacuum.
A sudden Chinese currency devaluation led in turn to sudden volatility which in turn triggered computerized trading strategies and ETF pricing difficulties that created a self-reinforcing downward spiral of 1000 Dow points. Some commentators to concluded that the downturn was not merely an overdue correction needed to spur more buying at more attractive valuations but rather the warning signs of global share market vulnerability and a potential bear market, with many US sectors and momentum-driven stocks already down over 20%, the traditional bear market benchmark.
Some even saw the stock price slide as a signal of a coming global recession that could spread to the US itself, despite final revised 3.7% GDP growth in the second quarter of this year -- especially if the Fed did not stay its hand. Meanwhile, the IMF and the World Bank have repeatedly warned the Fed not to raise rates just yet because of the effect it might well have on emerging market economies reeling from the impact of the Chinese economic downturn and currency devaluation.
The general sense in the markets and among commentators seemed to be summed up with the well-worn phrase that, in terms of interest rate policy, the Federal Reserve officials were "damned if they do" initiate a rate increase, and "damned if they don't" as well.
In its July statement on rate policy, the Open Market Committee itself said that in determining how long to maintain the overnight interest rate at the zero to .25% range, it will "assess progress - both realized and expected - toward its objectives of maximum employment and 2 percent inflation. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial and international developments.
"The Committee anticipates that it will be appropriate to raise the target range for the federal funds rate when it has seen some further improvement in the labor market and is reasonably confident that inflation will move n back to its 2 percent objective over the medium term".- Federal Reserve Press Release, July 29, 2015
In addition, in a speech in July, Fed Chair Janet Yellen added that the reference to "medium term" inflation for her meant over "the next few years". This fairly relaxed standard in terms of estimating the upward path of inflation suggests that current low inflation in the US and further deflationary pressures emanating from China may not be enough to tip the balance against a rate increase in September, especially given recent evidence of "further improvement in the labor market" --- including the September 9 release of record job openings in the US.
Even the lower than expected end-August payrolls report of only 173, 000 net new jobs , which also took the unemployment rate down to the 5.1% level expected by the Fed not before year-end, is likely to be revised upward by around 75,00 if the five-year average for August revisions holds.
Accordingly, the September decision seems to hinge primarily on the Fed's third decision factor: namely, the state of "financial and international developments". In that connection, the Financial Times reported on September 9 that the World Bank's chief economist renewed the warning that the Fed risks triggering "panic and turmoil" if it proceeds with a rate increase. Moreover, Citigroups' chief global economists opined that the Chinese economy was in worse shape than official statistics indicate and predicted that a coming precipitous fall in Chinese GDP growth would create a 55% chance of a global recession!
In this high-pressure context, it is best to ask ahead of time "What is are the Fed officials thinking?" before we ask later, "What were they thinking?"
Recent public speeches and interviews of the voting members of the Open Market Committee that will decide show a house seriously divided. Two voters, Jeffrey Lacker of the Richmond Reserve Bank and Dennis Lockhart of Atlanta, have both come out rather forcefully in favor of a rate increase in September even in the face of global concerns.
Charles Dudley of the New York Fed, hover, recently opined that the case of a September increase has become "less compelling". Also, Vice Chair Stanley Fischer gave an interview to CNBC that appeared to leave a September increase clearly on the table. But in a speech the next day observed that he and his colleagues "are following developments in the Chinese economy and their actual and potential effects on the other economies even more closly than usual".
Fed Governor Lael Brainard spoke in June of the danger of overestimating the positive effects of dollar appreciation and oil depreciation on the US economy, and underestimating the negative effects. Thus fed Chair Janet Yellen faces the prospects of more than one dissent from either a decision to raise the federal funds rate from it current range, of instead to continue with what Brainard called a policy of "watchful waiting".
The key fact is this: multiple dissents from any September decision would present serious market challenges to the Fed's credibility, so it is safe to assume that Chair Yellen will want to find a way to thread the interest rate policy needle in such a way as to keep any dissents to a minimum. Thus the most likely and optimal September policy choice would seem to be the one that would produce the fewest dissents. Could there be a way that both the rate "hawks" and "doves" could claim enough of a win to sign on to the statement without dissenting?
How about this: start with a achieving consensus that, whatever the international financial risks, the current level of strength in the US economy and labor markets is decidedly inconsistent with a "zero interest rate policy". No voting member of the Fed's Open Market Committee has challenged this view, regardless of whatever his or her view is of the world economic situation. Then consider the possibility that the Fed could simply abandon its "target range" focus (which it initiated only in December 2008 when it created to current range of zero to .25%) and revert instead to its former practice of setting a specific funds rate target.
Combining those two steps, it is conceivable that Yellen could limit dissents to either just one or even none by a decision at the September meeting to set the new specific "target" for federal funds interest rate at .25% -- ie, just dropping the zero rate!
Doing the latter should please (if not fully satisfy) the Fed "hawks"; and setting the new target at .25% -- consistent with the rate the Fed current pays on bank reserve deposits with the Fed - should mollify the "doves". Moreover, both the IMF and World Bank could reasonably conclude that going forward merely at the top end of the current target range would not constitute any real change and thus not e perceived as an attack on emerging market economies.
Call this maneuver a "baby step" or a "back to the future" finesse if you will -- but sometimes the simplest way is the best route out of a complex policy box!