Will the Fed Surprise Everyone?

In less than one hour, the Fed will give its decision on monetary policy. Here are a few things to keep in mind and what they mean for markets going forward. Labor market conditions have worsened in August, growth is sluggish, and core inflation is roughly on-target. Based on data, there is NO hurry to increase rates, which is why the market is pricing in a very low probability of a rate change, which indeed seems like the most probable outcome. But the probability of a rate hike may be higher than we all think. Here is why...

A few extras must be thrown into the mix: credibility, credit-induced bubbles, "breathing room to cut rates," and the signal effect to the market.

Fed officials have been more and more vocal about the need to start raising rates and that the market needed to take this "warning" seriously. They have been sending these "warnings" for over 2 years now... and again recently at Jackson Hole, a few weeks ago, Janet Yellen said that “...in light of the continued solid performance of the labor market and our outlook for economic activity and inflation," the case to increase rates is stronger and stronger.

This continued talk of raising rates is mostly based on the unemployment rate and the need to gradually and slowly return to a "normal" policy stance in anticipation of the second half of 2016, which the Fed estimates will be stronger than the first.

The case for a rate hike is certainly NOT caused by excessive inflation or "overheating" of the economy. It seems to be based on the need to start 2017 with an already-started rate hike campaign and for credibility issues. That said, a rate hike could also send a positive message to the market: the Fed would judge that the economy is "doing well enough" to warrant gradual policy tightening, which would not cause interference on elections. Although the short run effect would probably dent stocks, it could send a positive note to the market while at the same time re-establishing the "who's the boss" status of the Fed over its decisions and trimming the risk of asset bubbles caused by low interest rates.

After all, the Fed Funds Rate has been below the Taylor Rule rate almost systematically for the past 15 years, and strangely, we have seen bubbles and credit growth in excess of "normal" over that period as well. Granted, there is a global savings glut that just won't go away, but that is an ongoing thing.
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Of course policymaking is not as simple as following the Taylor Rule, and maybe the standard Taylor Rule rate does not take into account the lower neutral rate of the post-2008 context.

The Bank of Japan Joke
Tuesday, the BOJ announced a change in policy: it wants to have near-zero 10-year bond rates while keeping short rates negative to have a positive slope for the yield curve. You see, commercial banks "borrow short term and lend long term" and the difference gives them profit, because short term rates are (generally) lower than long term rates. A flat yield curve means that banks find funds at the same rate at which they lend, which means low profit margins...

So this tweaking of policy and playing around with the yield curve is the new twist out of the BOJ. It also "promised" to reach (and even overshoot!) its own 2% inflation target while still in deflation now... This would be accomplished by printing money and buying stocks via ETFs... WOW! Central banks messing around directly with stock market prices of individual companies!? I am no Friedman worshiper (nor a Friedman hater), but it gives me the impression that all this monetary alchemy has gone too far and we are in denial of the actual fundamental determinants of growth and prosperity...

Now how did the market take the promise of the BOJ to print and inflate? If the promise was taken seriously, you would expect JPY to depreciate versus the USD, which means you would expect the USD to increase in value relative to JPY... in short, you would expect a jump in the price of USD/JPY... here is what happened in the hours after the announcement:
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The market believed it for... 2 hours (the 2 big green candles)... and then the USD depreciated again versus JPY... So much for credibility of printing and inflating! The BOJ has no credibility because it can't buy enough bonds due to a wish to keep the 10 year bond yield at zero and it can't seem to print enough to inflate the economy... the market does not buy the talk anymore...

The Fed must juggle with the slow erosion of credibility, low-rate contexts that can be the cause of future bubbles and crashes, sluggish growth, no inflation pressure, lots of global uncertainty, and a coming election. Good luck Janet!

If the Fed does increase the Fed Funds Rate (and this is a possibility more than people think), it will be for credibility and to signal optimism about the outlook. If not, it will stay on pause until after the elections and it will play the communications game of warnings... maybe it will still stick for now, but they better watch out to not become the next BOJ...

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YourPersonalEconomist