A big week is upon us as the Federal Reserve Open Market Committee meets for their second two-day session. In anticipation of their meeting, market volatility is elevated somewhat, because so many traders are anxious to learn what direction the Fed will take their interest rate policy. There is general consensus that the Fed may officially pivot to a less dovish stance, but the market is still not convinced of a rate liftoff coming soon. Case in point: Fed funds futures are still only pricing in a 100% chance of a 25bps rate hike by October.
So, if the talk has been about the Fed’s likelihood of raising rates “in a couple of meetings,” why is the market (Fed funds futures) so convinced it’s further down the road?
The Fed has been telling us to be data-dependent for years – just as they are. At this point, the data has started to sour. Is it enough deterioration to warrant more patience? That is the $64,000 question, and the Fed will be considering an answer before their meeting is adjourned. The committee will also present a revised economic projection of growth, inflation and employment forecasts, which will give us some insight into how they view the recent drop in inflation. Is it transitory, or something more permanent?
We have often found the committee to be more sanguine about fluctuations; they allow excessive room to let these situations work themselves out. Take the jobs situation. The higher employment rate post-financial crisis worked itself out over time as the Fed was more patient with their policy. As they predicted, we are moving towards a sub-6% employment rate. Though there is still tremendous slack in the labor pool, is that rate enough to put some pressure on inflation?
Don’t forget, the Fed is still a big believer in the Philips Curve, but right now, wages are not moving the curve to a normal inversion (it has been a mirror image for a few years now). If the committee believes inflation expectations will begin to rise along with wages, then there is a strong argument to raise the funds rate.
And how about the strong dollar? Clearly, many traders and investors are moving away from the Euro and other currencies, especially now that global central banks are taking on a more active role to ease money levels. The greenback has been a huge beneficiary of a global easy-money policy, if for no other reason than the economy is showing better growth than others.
Can that continue? I would argue that a strong dollar is good not only for the US but for the entire world. Currency fluctuations are just a temporary state for the business world that are eventually are resolved. Remember just a few years back when the dollar swooned and reached the 70’s level on the DXY? Many analysts said the currency would be removed as the world’s reserve. That idea has long since vanished, of course.
Yet, many believe the dollar cannot continue higher without having a negative effect on global growth. I refer you to the 1980’s and 1990’s when a strong dollar policy helped increase the standard of living of US citizens and wealth creation occurred at historic levels. Larry Kudlow, an expert economist and forecaster from CNBC, is a well-known champion of a strong dollar policy, and he states it would be a boon for the world to see the dollar continue to strengthen.
As for the Fed policy, let’s pay close attention to what Janet Yellen says in the press conference following their meeting. She believes in sending a strong message, and, like her predecessor Ben Bernanke, she is known for being really be clear on policy. I suspect we will not be disappointed. As a result, we should see volatility drop a bit and investors and traders breathe a collective sigh of relief.