Mixed data leaves Fed-watchers scratching their heads

Solomon Teague
Published on:

Predicting interest rates is not an Olympic sport, but the job of discerning what the Fed has planned is arguably as taxing as anything Rio is serving up. With economic signals strikingly mixed, and forward guidance offering little additional insight, economists appear to have little conviction in their predictions regarding the Fed's intentions.

Fed-watchers should focus less on Fed policymakers for guidance and more on incoming data. That, at least, was the interpretation by financial services firm Brown Brothers Harriman (BBH) of Ben Bernanke's recent Brookings Institution blogpost, in which he warned that "Fed communications have taken on a more agnostic tone recently", arguing that a slower pace of normalization of US monetary policy is increasingly likely.

Yet scrutinizing the Fed's comments for clues about future policy has become one of the key pastimes for global economists, and it is a habit they are unlikely to kick any time soon – especially with so little clarity coming from other indicators.

"There is more diversity of opinion on the street and within the committee itself about what the Fed will do, and what it should do, about rates," says Subadra Rajappa, head of US rates strategy at Société Générale. "This follows a long period where we have seen every good quarter followed by a bad one."

Subadra Rajappa,
Société Générale

Amid the confusion, it is natural that analysts look to the decision makers for clues. At its recent meeting, the Federal Open Market Committee (FOMC) observed that near-term risks – financial market volatility, weak oil prices and the cloud cast by the UK's Brexit referendum – had diminished.

This, HSBC analysts conclude, "takes pressure off of the Fed to ease monetary policy to offset a potential deterioration in the economic outlook. However, it does not necessarily create conditions for the Fed to tighten policy in the near term."

Looking at the underlying data, HSBC notes that "revised data following the latest annual benchmark revision to GDP show a clear picture of a steady softening in growth over the past year." 

GDP growth slowed to 1.2% in the four quarters ending Q2 2016, down from 3.0% in the previous four quarters. "We believe this deceleration in growth will make the policymakers at the Fed more cautious about tightening monetary policy in the near term," states HSBC.

The employment numbers have not triggered a strong response from the dollar. 

Petr Krpata, an FX strategist at ING, says: "The key focus will be on chair [Janet] Yellen’s speech at Jackson Hole at the end of the month. Until then, it is hard to see meaningful USD gains against EUR or JPY."

All about the data

Yet currency movements might not be the best place to look for clues about future interest rate policy. 

"The Fed's hesitancy in lifting rates is not due to the dollar any more," says BBH in the same research. "Rather, it is about poor data, such as the poor May employment report and disappointing GDP figures.

"The state of play is fairly straightforward. The Federal Reserve is finding it difficult to take the next step in the normalization of monetary policy. According to Bloomberg calculations, the Fed funds futures strip does not show greater than a 42% chance of a rate hike at any meeting through the end of next year."

Société Générale's Rajappa says: "A rise in rates from 0.25 to 0.50, or from 0.50 to 0.75, is not that meaningful as far as the US economy is concerned. It is not going to make a huge difference to borrowing costs. But for the dollar, and for financial conditions, for interest-rate differentials at the front end, it is significant. That is why this is such a difficult call to make."

The uncertainty also reflects deeper questions around the effectiveness of the policy levers being pulled by central bankers as they struggle to influence the global economy. In the UK, the Bank of England recently cut rates by a quarter of a percentage point to 0.25%, and announced an expansion of its quantitative easing (QE) programme, but doubts still remain about the impact the measures will have on growth.

To the extent that these measures are effective, policymakers are also coming to terms with the increasing prospect of the next recession starting while rates are still at rock bottom. While QE and negative rates show that the monetary tank is not quite empty, these levers are finite, and doubts about their effectiveness are feeding speculation about alternative solutions.

One possibility is an increase in the inflation target, says JPMorgan. While such a strategy looks pointless in Europe and Japan, where central banks have been unable to hit inflation targets despite easing, the US is contemplating tightening, meaning this could be a viable option.

"Were the Fed to adopt a higher inflation target now, this would lead to an immediate repricing of the path for policy rates, and likely a material easing of financial conditions," says JPMorgan.