As things stand markets appear to be pricing in the prospect of a September rate rise at about a 30/70 probability as US data continues to give conflicting signals as to the underlying strength of the US economy.
A lot has been made of the fact that in the last Fed statement the insertion of “some” into the third paragraph appeared to suggest that the bar to not acting on rates had got that little bit higher, a belief reinforced by subsequent comments from the Atlanta Fed President and FOMC voting member Dennis Lockhart in the past few weeks.
As a reminder the line in question relates to the US labour market, namely it would be “appropriate to raise the target range for the Federal funds rate when it has seen some further improvement in the labour market.”
The continued improvement in the US labour market certainly reinforces a narrative of an improving economy, if you ignore the pitifully low participation rate, but it also appears that investors are choosing to ignore another significant factor in the most recent Fed statement, maybe because it doesn’t suit their narrative.
It is however no less important given its relevance to the sharp decline seen in energy prices. It was notable that the Fed statement also saw reference to the stabilisation in energy prices removed, and this scarcely got a mention, despite the fact that oil prices are over 25% down from when the Fed met in June.
US Oil prices were above $60 a barrel when the Fed met in June this year, and are now trading at six year lows near $42 a barrel. Is it reasonable to assume that US policymakers will ignore the so called transitory effect of lower energy prices when compared to June 2014 prices are down from peaks of $108 a barrel?
Furthermore since June 2014 the Reuters CRB index has slid from $310 to multi year lows below $200, and the lowest levels since 2002, a decline of over 35%. In fact it has been in decline for over four years, and is now at levels last seen in 2002, which by any definition can hardly be called transitory. The Fed really needs to find a different narrative.
It now appears from the most recent minutes of the July FOMC meeting that Fed officials do have concerns about the low rate of inflation, as well as the strength of the US Dollar and events in China, and that was even before this month’s Chinese devaluation, so their concerns are likely to be more pronounced now, particularly given the sharp declines seen in the past two weeks, as concerns over the Chinese economy grow ever larger.
This is why the upcoming annual central bank symposium in Jackson Hole Wyoming could well be significant in the context of what the Federal Reserve might do next month. The subject up for discussion will be “Inflation Dynamics and Monetary Policy”, which is rather topical given the debate currently raging about the lack of inflation globally.
In previous years the annual Jackson Hole central bankers symposium has acted as an important bellwether in terms of what the Federal Reserve and other central banks might do in the context of monetary policy, though this year it seems that markets are attaching less importance to it largely because of the absence of Fed chief Janet Yellen this year.
This could well be a mistake given that the Fed has a dual mandate and it is missing its inflation target by a country mile, with the recent rise of the US dollar keeping inflation significantly subdued.
Since June 2014 the US dollar index has risen around 20%, while at the same time commodity prices have declined 35%.
The Federal Reserve along with other central banks has consistently maintained that the declines in commodity prices are transitory in nature, however recent events in China would appear to suggest that the low inflation environment is anything but transitory and that what we are currently experiencing could well have further to run, especially if the Yuan continues to slide.
Given all of this there still seems an almost indecent haste to try and nudge rates higher by the US Federal Reserve, but there is a danger they could well reinforce the negative downward spiral in prices that we’ve seen in recent months, particularly if it pushes the greenback even higher.
Fed hawks will argue that rates at 0% to 0.25% are an emergency setting, and that markets will be able to absorb a move higher to 0.25% to 0.50%, but this overlooks the vital fact that the Fed has downgraded its growth forecasts twice already this year.
They are certainly correct that rates are on an emergency setting, but the time for hiking was 12 months ago when the economy was stronger than it is now. If they weren’t prepared to hike then when the economy was stronger, why on earth in the current environment take the risk now, when inflation remains benign and could well decline further, and stock markets are sliding sharply on the back of rapidly declining fundamentals.
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