We have come to that point: The Fed has painted themselves into the corner with their current policy, and the only real way out is to distribute the pain to the markets. Here’s what going on with Fed policy now – and what to expect this year.
The Fed currently seems quite confident about the prospects for economic growth and rising inflation, which is why they were comfortable raising interest rates last month by 1/4 point – the first such move in nearly a decade. In meeting minutes that were released last week, they also expressed confidence in the employment outlook, and indeed the December report (issued on January 8) confirmed their stance.
Meanwhile, the Fed has to keep China in mind. The last time China roiled markets was just before the Fed’s September meeting. At that time, Federal Reserve Chief Yellen voiced her concern about the ripple effects of abnormal policy procedures from the world’s second largest economy. Further, there is an understanding that China’s economic growth expectations need to come down and that, if there is a bubble in Chinese stock markets, then those investors are looking at a hard landing.
Given this landscape, even the most dovish of Fed Governors (specifically Charles Evans and Lael Brainard) believe rates should rise at some point. Though they are not in agreement with members on the number of hikes in 2016, that potential number is still in the air. New voters on the committee include those with a hawkish view, but we have yet to hear their position other than in forecasts from last month’s meeting (dot plot). The frustration, of course, is the lack of apparent inflation building within the system, as that would trigger even more hawkish policy directives.
Fed members have been all over the map as they have discussed Fed policy lately, though it’s notable that some of the most hawkish ones have toned down their rhetoric. St. Louis Fed President James Bullard pulled back on inflation talk, while New York Fed President William Dudley had mixed comments. Their comments tell us that they prefer not to guess, but it still leaves us to wonder how quick they will shift Fed policy when it becomes necessary. Will the Fed hike rates quickly if inflation rises sharply? You better believe it! But what will happen if their inflation and growth goals are not met? This uncertainty has caused the markets to send a resounding message: so far in 2016, the SPX 500 is down a staggering 8%.
Now, all the blame cannot be put at the doorstep of the Fed, but an aggressive easing policy needed to be better managed for an upcoming shift. I don’t believe the Fed is managing it well, and the markets seem to agree. They teeter with every word and number from the Fed, specifically around the number of rate hikes to come in 2016. Some say four hikes, others say two – and this difference is currently hurting the markets. (Either number is considered a gradual pace according to recent Fed comments.)
The bond market is not convinced the Fed has the courage to hike even at a slow pace; it seems to believe that an economic slowdown will halt any additional action. The economic data reflects this sentiment, too, and the bond market is seldom ever wrong. The Fed knows it – and they are listening carefully.
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