THE BLOG
01/21/2016 04:46 pm ET Updated Jan 19, 2017

Four Ifs by Fed, Two Ifs by Me? Why the Reserve Board Will Likely Keep Its Interest Rate Powder Relatively Dry in 2016

Since announcing last December that it would increase by .25 percent the range of its base interest rate for overnight lending for nearly a decade, the US Federal Reserve has signaled in multiple ways its intent to continue such increases four times during the course of this year. Initially, this intent was signaled by the release, in conjunction with its last 2015 meeting, of the "central tendency" of the projections of the rate-setting "Open Market Committee" participants (the now famous "dot plots" on a graph). Those plots showed that, disregarding the highest and lowest projections, the middle of the pack of opinion was represented by a path of four rate increases of .25 percent each by the start of 2017. While this would be a slower than usual pace of rate increases by past Fed standards, it would nonetheless bring the base rate to a range of 1.25 - 1.50 percent, essentially a full point higher than where the range stands today.

Ever since then, the US financial markets have more or less indicated their displeasure with this "tendency" in the best way they can to get attention. Bond markets rallied with prices higher and interest rates lower, reflecting a conviction among market participants that economic conditions have veered downward with deflation, rather than moving in the direction of continued modest expansion and 2 percent inflation projected by the Fed at its December meeting. Lately, a number of market participants are going even further and predicting the onset of a US recession (two or more consecutive quarters of negative movement in GDP), which would certainly argue for more, not less, Fed "accommodation" to the market--either in the form of another round of quantitative easing in bond purchases to pump lendable money out to banks, or course-reversing decreases in the base interest rate (for which the Fed has only marginal room at best before "going negative," as Europe has).

Regardless of whether the bond market is right in suggesting a recessionary case, the equity market, which has been at odds with bond market expectations for most of the last few years, has also been shooting flares at the Fed's intentions in very dramatic fashion. Indeed, there is simply no historical precedent for the precipitous drop in US equities since the first trading day of the year, when on average an investor lost $16 for every $1000 in the market and has kept on losing money ever since through the first two weeks of the year.

There are, of course, multiple rationales for the equity market correction (a 10 percent drop or more), the second in six months. Indeed, some of the reasons are the same as occurred in August: data showing a serious decline in the Chinese export economy, and a precipitous devaluation of the Chinese currency in the context of continued relative strength of the US dollar, as well as the partially-related continuing decline in the price of oil in view of increased current and anticipated market supply and weakening Chinese and emerging market demand, which also led to a drop in the pace of US manufacturing! In addition, there was a perception in some market quarters that the Federal Reserve might take steps to increase interest rates in September, while the US economy was showing signs of increasingly vulnerability to foreign emerging market damage, caused by the rising value of the US dollar against their currencies (exacerbated by the drop on the Chinese yuan) and the ensuing flight of capital from their economies--which would be made worse by such an increase.

Ironically, the decision of the Fed to hold off an expected September rate increase was roundly criticized in some quarters because the Fed expressly cited global economic conditions potentially threatening the US recovery as one of its reasons for deferring the first increase at that time. These critics said the Fed has no business taking foreign situations into account to the extent that it seemed to be adding a "third mandate" in terms of global financial market stability to its list of responsibilities.

Now, the Fed was never adopting a third mandate to work for foreign countries. Its September focus on negative Chinese and global economic trends was quite obviously because of the potential US-side effects of those negatives on the Fed's statutory twin mandates--optimal employment and stable prices! Indeed, today's Fed critics are adopting that very same perspective the Fed was criticized for back in September, urging the Fed to most certainly pay heed to the adverse developments in the Chinese and emerging market economies because they may be leading to a global recession that will be imported along with attendant deflation to the US.

Nonetheless, in the past week, both Vice Chair Stanley Fischer and New York Federal Reserve Bank President William Dudley went out of their way in public remarks to assert that the projected four rate increases this year were still "in the ballpark" and definitely on the table, notwithstanding the offshore negatives. Yet the minutes of the Fed's Open Market Committee's December meeting, released January 6, reveal the Fed itself was divided and unsure of the direction of the US economy, citing "significant concern about the still low readings on actual inflation" and "risks present in in the inflation outlook." These concerns would now seem to be increased by the continuing drop of the current market price of oil to levels below $30 per barrel, not seen since 2003.

Coincidentally, the same Business Section of The New York Times that offered the headlines "Oil Prices Decline More than 5 Percent as Stockpiles Increase," and "New Fears of a Slowdown in China Spur Selling" (January 7, 2016) also contained the article titled "Minutes Indicate That Fed Still Has Inflation Doubts." The story noted questions about how much farther Fed officials are willing to raise rates without clear evidence the pace of inflation is also rising. Fortune Magazine had a similar take on the Fed's divided state of mind.

In the coming days and weeks, there will be multiple data points to be considered before the Fed's coming January and March meetings (nobody expects a rate increase in January, but the "four more hikes" play call virtually requires one in March) by a Federal Reserve that has promised its interest rates decisions going forward will be "data dependent," regardless of their dot-plot projections: fourth-quarter 2015 GDP (currently within 1 percent or less of recession levels in most forecasts); January and February employment reports; manufacturing and service business trajectory; consumer spending levels; retail and housing sales; and, of course, producer and consumer price levels. A generally centrist Fed official, St. Louis Reserve Bank President James Bullard, while not directly contradicting the "four more in 2016" rate rise track, did note the potential impact of falling oil prices on the Fed's 2 percent inflation target. This note may well imply that such incoming data will prove to be more important than the dot-plot projections of four rate increases this year, especially because of the effects of further downturns in China on the drivers of that data, such as the price of oil and the prospects for currency-related, deflationary discounts on products imported to the US.

But there have been very few mentions of another factor that could tip the balance against four or more rate increase this year: 2016 is a presidential election year. The Fed meets only eight times a year, so four increases would average one increase every other meeting. Assuming the incoming data causes a March deferral, that would leave only six for four, right into the teeth of the nominating and final election campaign. George H. W. Bush famously blamed his re-election loss in 1992 on the Fed's Alan Greenspan, for his resistance to cutting interest rates faster during the recession preceding the vote.

The Fed certainly would want to avoid a mistake in terms of excessive interest rate increases that tip the economy into recession (that's why its public statements hedge with respect to "data dependence"). But it would also not want to be perceived to tip the election to one candidate or another; let's just call that "date dependence"--the date of the election! The prediction here is that this year will see two rate increases at most: one in April or later, and the other after the election in December.

For the moment, Chinese GDP data has come in at 6.9 percent for 2015, down .4 percent from the prior year and in line with reduced expectation, stabilized by retail sales growth of 11.1 percent year over year (just short of estimates), while manufacturing contributions continued to tumble as expected.

These numbers reflect an overall 25-year low in GDP, but also suggest a level of stabilization that left markets in Asia marginally positive, with
Shanghai up slightly as well. What remains to be seen is whether these numbers will in turn stabilize the US markets enough for the Fed to jump ahead with a .25 percent increase in March. And that would seem to turn on whether the strong employment data averages of 284,000 net new jobs in Q4 2015 will persist, and whether there emerges actual (not just projected) upward inflation data in Q1 2016. The sense here is "no" on both counts--and that might mean the US equity market could even turn upward, as it did eventually after last September's Fed flinch.