Concern about global conditions is running the show

Outlook:

The Fed stunned mar kets expecting a fair amount of hawkishness. Instead the Fed was cowardly and cautious without really disclosing all the reasons why. This makes you wonder what the Fed knows (or suspects) that the rest of us do not. In summary, the Fed admitted the pace of activity is expanding at a moderate pace despite recent global developments—but then declined to use the phrase “balance of risks.”

The expected Fed funds rate at end-2106 is 0.9% from 1.4% in Dec and 1.9% at end-2017 from 2.4% in December—two hikes this year, not four. GDP will be 2.2% (from 2.4% in Dec) and headline inflation will be 1.2% instead of 1.6% forecast in Dec.

Bottom line, the Fed expects the Fed funds rate to end the year at 0.875%, according to the new dot-plot, and 1.875% by the end of 2017. It should be 3% at the end of 2018. This is not a plan or a promise, just a best estimate. Note that Kansas City Fed Pres George was the lone dissenter—she wanted a hike.

The FX market expected a more optimistic and less cautious Fed statement. Positions set up for a hawkish outcome had to be reversed. We expected a bit of a surprise, but not this one. Most interesting was Yellen’s comment that applying caution will “allow us to verify the labor market is continuing to strengthen despite the risks from abroad.”

Wait a minute. We have had over 70 months of steadily improving jobs numbers. What, exactly, needs verification? A subheading in the FT describes it perfectly: “Investors ask if FOMC scrutiny of market moves trumps economic data.” In other words, the Fed may be data-driven but it’s not the data we were led to believe.

The FT makes another wildly interesting point—the 5-year TIPS breakeven rate rose sharply yesterday to 1.5% for the first time since July. A Pimco advisor said “The break-even reaction tells you all you need to know. The Fed is telling us that they’re willing to allow an overshoot in inflation. They really want to get inflation expectations higher.” But as we reported only yesterday, the NY F ed had just found inflation expectations on the rise.

And yesterday’s CPI was up 1% y/y in Feb, with core CPI up 2.3%, the biggest 12-month rise since May 2012. The Fed’s favorite measure, the PCE price index, is up 1.3%. Inflation is picking up and so are inflation expectations. Even the Fed statement says “Inflation picked up in recent months,” but Yellen says she is wary that the upturn will continues because it is driven by “volatile categories.” She said “Caution is appropriate.”

Oh, please. Why not just come right out and say the Fed needs to see oil stabilize at higher levels before it agrees inflation and inflation expectations are sustainable? This refusal to deal with oil is becoming seriously tiresome.

When asked in the press conference about oil prices rising to say $50, Yellen admitted such a move would alter the speed at which the 2% inflation target would be met, but otherwise would not be of "great policy significance." We are amazed that other economists are not objecting to this stance. As we showed in the FT chart only yesterday, inflation expectations and the price of oil are tightly correlated.

The other big factor is global market turmoil that the Fed wants to see tamped down—by how much and for how long, we don’t know. The Fed gives us metrics for its other policy targets—inflation, unemployment— but no guideposts for “global market conditions.” This, too, is not acceptable in the sense that we have to guess—in the face of a central banks that prides itself on transparency and clear communication. You have to wonder if the Delphic Fed of decades ago is not returning. Greenspan started the trend (reluctantly) toward greater transparency after the Debacle of 1994, and it has continued for the 22 years since—but the Fed being transparent is a choice, not a requirement. It now looks like the Fed is becoming secretive again.

As many observers are noting, it’s entirely possible the Fed will be behind the curve again at some point this year, assuming inflation really is on the rise. We are sure to see somebody start asking whether the Fed pulled in its horns because it wanted to stop the dollar rally. This is akin to a conspiracy theory and impossible to prove or disprove. We doubt the Fed is trying to manage the dollar at all.

What we can see is that concern about global conditions is running the show, not jobs and inflation.
Bloomberg admits “Yellen didn’t spend a lot of time enumerating the risks to the global economy. She talked about a ‘slight downgrading’ of global growth forecasts. China’s slowdown ‘hasn’t proven a great surprise,’ while China and Mexico are feeling the effects of lower oil prices, she noted. She also pointed out that the FOMC decided not to say that the risks to their outlook for the U.S. were weighted to the downside. ‘The committee did not reach that judgment,’ she said. Taken together, however, the general slog of growth world-wide is why ‘a slightly lower path for the federal funds rate will be appropriate to achieve our objectives,’ she said.”

Oh, please. Since when does the Fed make policy because of what is happening in Mexico? The real focus should be the eurozone and what Mr. Draghi is trying to accomplish. Emerging markets may be 40 -50% of world growth and China may be the second largest world economy, but in the developed world, there are really only four players—Japan, the UK, the US and the eurozone. And of these, the ECB is the most important player because of the policy divergence theory that has driven the FX market for so long. Nothing that happened last week at the ECB policy meeting or this week at the Fed’s meeting changes anything except the pace of the US move. The direction is the same. But boy, you can’t bet on it today. Not to be too extreme, but the euro can rise to the weekly channel top around 1.3000 before we get this divergence effect.