Fed: On a prolonged pause as central governments take control

Background – Fed backtracked from its Dec 2015 hawkish view

Fed’s rate hike in December 2015 was accompanied by a hawkish Dot plot chart, which suggested the bank would move four times in 2016. That meant a rate hike probably at every quarter end meeting – March, June, September and December.

But what we have seen since January meeting is a slow and steady back tracking by Fed from its hawkish view. Fed cited domestic slowdown, overseas risk and ‘N’ number of reasons for backtracking from its hawkish view.

Fed policymakers don’t walk the talk

Over the last nine months we have seen that Fed officials do not walk the talk. A number of Fed officials, even the well known ‘doves’, have repeatedly hit the wires suggesting the bank could still move rates at least once if not twice this year. However, what they say at their appearances at various events completely contradicts what they do at the rate decision.

Furthermore, there is a pattern = Two doves talk up rate hike expectations before one of the policymaker comes out squashing rate hike bets. The latest example of this is Fed’s Brainard killing rate hike bets last week with her dovish talk. The net result is the market no longer trusts what the Fed officials say.

Central Banks have set stage for fiscal splurge

This might sound like a conspiracy theory, but let’s have a look at it once. Over the last two years, advanced nation central banks except Fed have moved rates to negative territory and initiated massive QE programs. Moreover, central banks have exhausted themselves.

This appears to be a deliberate effort in order to force governments to ditch austerity and embrace fiscal stimulus. Since late 2012 or so, there has been growing talk about the failure of austerity, especially across Europe. However, governments across the advanced world stayed away from spending and relied too much on central banks. The only way governments could be convinced or let us say forced to fiscally stimulate the economies was through exhausting monetary policy tools to an extend that would make markets jittery.

Moreover, exhausting monetary policy tools means risking having an asset price bubble burst. Note that asset price bubble burst is deflationary and that is the last thing governments would want to have.

The above argument perfectly fits the current scenario –

• There is little or no growth
• Prospects for a recovery in oil or commodity prices are next to zero
• There are asset bubbles everywhere
• Central banks stand exhausted
• & markets are increasingly jittery about central bank liquidity tap drying up, thus risk of an asset crash is high.

No wonder, words like ‘fiscal stimulus, Fiscalism, fiscal spending’ have started hitting the wires more often now. Eventually, what we are likely to have is a combination of low rates plus fiscal effort.

Note that central bank exhaustion does not mean interest rates would be hiked. It only means further rate cuts are unlikely as the tools have lost their marginal efficiency (effectiveness).

Fed Scenario

I am backtracking slightly from my view presented on July 1, 2015 here: “US QE 4 in mid/late 2016… after two symbolic rate hikes in 2015/early 2016”. Over here I had argues that Fed could hike rates in September 2015/Dec 2015 followed by another rate hike may be… followed by a rate cut and QE4!

However, actions by other major central banks, most notably the BOJ and the ECB have set the stage for fiscal stimulus as discussed above.  Given the overall situation, following Fed scenarios could unfold in the future.   

The most likely scenario is another rate hike may be followed by a prolonged pause amid a major fiscal stimulus effort elsewhere.

Rate hike and a prolonged pause – By now it is quite clear that we are operating in the ‘new normal’. Hence, the current policy tightening cycle is unlikely to be a similar one to the seen during previous boom-bust cycles.

At most, we could have one more rate hike. Take note of the fact that US GDP has been averaging just 1% or so for the last few quarters. Hence, rates could go at max to 1%. That means scope for just two rate hikes. However, in the current scenario of a threat of deflationary crash and ultra low rates across the advanced world, the Fed is unlikely to hike rates twice. At the most, one more rate hike to go followed by a prolonged pause.

Accompanied by fiscal spending – Joint effort or a single gigantic effort

Firth things first, governments would be forced to come up with fiscal stimulus efforts once stock markets suffer a major bout of correction. In case of Dow, it means the index sliding below 38.2% Fibo of 2009 low – 2015 high.

Who will go first?

Bank of Japan is the first to hit the skid roads so ideally Japanese government could be the first to announce a major stimulus package. However, when we talk about Japan, the word ‘major’ represents an altogether different meaning. In the current scenario, it represents helicopter money.

German has a lot of space to run fiscal deficits. However, convincing Germany to run fiscal stimulus is extremely difficult. Meanwhile, UK is surely heading towards fiscal stimulus.

Difference between fiscal stimulus and monetary stimulus

Monetary stimulus in post-GFC era is equivalent of currency wars. The primary difference between monetary stimulus (currency wars) and fiscal stimulus is that in currency wars, nations import or should I say steal the foreign demand, while via fiscal stimulus; the governments create artificial domestic demand. A single nation, if it comes up with a major fiscal stimulus effort, could absorb exports from the other parts of the world. Because a nation devaluing its currency (via monetary stimulus) steals the foreign demand, other nations are forced to retaliate … thus leading to currency wars. In case of a fiscal effort, creation of artificial demand could help other nations export their way out of recession

Hence, Fed could enjoy a prolonged pause as central governments take over from central banks. As said earlier they have been forced to take over and the final blow is likely to come through from a bout of financial market instability.

Case for Fed rate cut/QE 4

This is an easy one. Financial market instability could force Fed to ditch policy tightening and initiate rate cut or even move towards QE4. But the question is how much of a drop in stocks opens doors for Fed easing? 

As discussed in the Dow Jones H2 forecast here: “Dow Jones Forecast H2 2016: Is it different this time? Or will we have bearish divergence”), traders could expect fed easing talks to gather pace once the index breaches 23.6% Fibo support of 2009 low - record high. A rise in rate cut bets could be followed by QE4 talk if the fall extends beyond 38.2% Fibo level of 2009 low – record high.

Also note that the financial market instability is likely to force governments to initiate fiscal stimulus plans, hence QE 4 appears a distant dream… something that Fed would be forced to do if the governments don’t step in and a correction would turn into a crash!

Fed U-turn could force RBA and RBNZ to zero lower bound

RBA and RBNZ are largely at the mercy of what the Fed does. The more dovish Fed becomes, the more is the danger of RBA and RBNZ eventually moving towards zero lower bound. AUD and NZD, being high yielders, risk strengthening as they did over the last few months on falling Fed rate hike bets. A sustained yield differential rally in AUD and NZD would eventually force RBA and RBNZ to make an aggressive move towards zero lower bound.

To conclude - we are most likely heading towards an era where ultra-low interest rates are accompanied by fiscal stimulus. Fed, having raised rates once could initiate at the most one more rate hike, before hibernating for a prolonged period of time and watch central governments take center stage.