The Fed will dominate the day

Outlook:

The Fed will dominate the day. Aside from those who still want to argue that the Fed acted too soon and may have to retreat, we actually have a fair amount of consensus. Nobody expects any policy action today and everybody expects the Fed to make some gloomy noises about the expected rise in inflation being deferred to farther out the time-line—just as Draghi said.

We also expect the Fed to mention market turbulence but here opinions diverge. If the Fed seems to be really spooked by market turbulence, it will be interpreted as a deferral of a putative March action. This interpretation would be strengthened if the Fed names the too-strong dollar in the next breath. But, as we wrote yesterday, it won’t pay to put too much weight on any mention of the dollar. As G7 leader, the US simply cannot adopt a preference for depreciation. Central banks in Australia and New Zealand (and even Canada) can do that, but not the US.

If March action is going to be deferred, it won’t be because of market turbulence or the dollar, but rather decelerating US growth. We get the Q4 GDP estimate on Friday and the Fed almost certainly has re-ceived advance notice by now. If the rate of growth has slowed to 0.8% (the Bloomberg estimate), the Fed may be inclined to offer dovish forward guidance.

Having said that, the Fed doesn’t like forward guidance much anymore. It prefers to emphasize it is “data-dependent.” This seemingly simple term has come to mean nothing at all. Which data? We already know unemployment has fallen to around 5%, so goal achieved. Inflation is the problem. The Fed ac-cepts the thesis that a shortage of workers will eventually drive wages up, and rising wages will drive demand. Higher demand leads to higher prices. Fait accompli.

Too bad it’s not actually working, at least so far. We have gone from a global economy driven by de-mand, with supply straining to keep up, to one characterized by excessive supply. It may not matter if demand rises when oversupply is such a massive problem. In other words, oil is not the only thing with a glut. We have a glut in steel, toys, shoes and anything else you can name.

In Japan, the government can’t drive demand in an ageing population concerned about savings and with no housing space to put Stuff, anyway. In the US, the baby-boomers are retiring at a rate of 10,000 per day and down-sizing, while the millennials are a whole lot less interested in owning stuff—they rent, they don’t buy. So, even if sentiment is fairly positive—as the Conference Board consumer sentiment index indicates—it may not translate into an actual rise in consumption. In the charts below, core CPI is on the left and PCE prices on the right.

One thing that prods consumption to be accelerated is expectations of looming inflation. We don’t have such expectations today, although the trajectory is promising. See the big chart below from tradingeconomics.com. Actual inflation, in the form of PCE and core CPI, also looks relatively healthy, if you look at the slope and not the numbers themselves. The numbers themselves are awful—PCE prices up a mere 0.3% in Nov, the last release.

Maybe the Fed is looking at the slope and not the numbers. We probably should approve—we like slope, too. It measures momentum. All the same, it’s hard to feel pro-dollar when the Fed is so likely to disap-point today. Bloomberg reports the probability of a second hike in March is at the lowest since last Octo-ber. Bloomberg also notes that the opening paragraph of the Fed statement will be about the overall economy and the Fed will be hard-pressed to say growth is “balanced” or “moderate,” not with retail sales down in Dec and other measures showing declines, too. And can the Fed be positive about inflation expectations when growth is clearly slowing? That would be a fine demonstration of tap-dancing.

Nobody thinks the Fed can pull it off. See the FT’s Fed hike outlook on the next page below.

At a guess, today would not be a good day to count on monetary policy divergence favoring the dollar over the euro, even if in the longer run Big-Picture, divergence is still a valid thesis. That doesn’t mean the euro spikes higher on the Fed statement, but the risk is high. As usual when a major central bank is about to come on stage, we advise the wise course is to get out of Dodge.

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