Salman Ahmed (pictured), chief strategist at Lombard Odier Investment Managers thinks the Fed is more likely to hike in December than now. But the more important question, he says, remains whether the Fed will be able to run a sustained tightening cycle in a world of wide-spread disinflation/deflation.
Reasons against the hike
Both market pricing and survey data show a clear-cut shift away from September’s lift-off date in recent weeks, on the back of the very sharp China-induced hit to global confidence in mid-August.
For example, according to survey-based expectations and market pricing for a September hike is now well below 50%, compared to around 80% and 60% respectively in July.
The sharp fall in expectations for a September hike is in itself a problem for the Fed, as a move at the upcoming meeting will be seen as an expectation shock. Senior members of the Federal Open Market Committee (FOMC) have already indicated that such a policy shock is something they would like to avoid.
The recent disturbing dynamics in Chinese asset markets in the aftermath of the decision to let the currency depreciate has focused market attention towards the possibility of a hard landing in the world’s second largest economy.
The combination of the sharp fall in global equity prices, widening in credit spreads and the rally in the USD have tightened financial conditions in the US. This also argues for a wait and see approach, given the high degree of external uncertainty.
Lastly, let’s focus on domestic US data. The inability of inflation to pick-up pace (both core and wage growth) despite the significant improvement made on the labour market side of the ledger continues to provide arguments to the doves of the FOMC.
They would like to reduce the probability of recession concerns on the back of premature tightening of financial conditions.
Indeed, the sharp fall in commodity prices in recent weeks add further weight to these arguments, given that headline inflation is likely to fall below zero once again in coming months.
Reasons supporting the hike
Focusing on pure activity data then it is hard to argue that the US economic environment is not ready for a hike (in fact one can argue that the Fed is behind the curve).
Specifically, the unemployment rate is within the natural rate expectations of the Fed (5% to 5.2%), initial claims are near their cycle lows and business survey data are consistent with solid growth dynamics.
The relatively strong activity numbers metrics clearly play to the “data dependency” stance adopted by the Fed recently as it started the long and arduous process of preparing the markets for an eventual start to the tightening cycle.
Indeed, one can argue that not hiking now will further complicate the Fed’s eventual exit.
Standard reaction function representations such as the Taylor rule (which helps with central bank communication) will continue to be even more irrelevant going forward, which implies further loss of policy clarity and potentially credibility.
Fed tightening in a world of disinflation and differentiation
In our view, the events of the last few weeks clearly show that running an independent monetary policy for key central banks such as the Fed continues to be difficult.
The European Central Bank (ECB) and Bank of Japan (BoJ) are now preparing themselves for another dose of monetary stimulus as the sharp fall in commodity prices again creates sustained pressure on their inflation targeting objectives.
Already, by changing the technical parameters of the current buying programme, Mr. Draghi has given a powerful signal that the ECB is ready to expand QE in order to achieve its inflation objective.
In our view the BoJ is likely to follow suit given weakness in the domestic economy.
In addition, dynamics in a number of key emerging markets remain worrying with signs of a sharper growth slowdown in China coupled with serious idiosyncratic risks in countries such as Russia, Brazil and Turkey.
The continued upward pressure on the dollar (partly to do with Fed hiking) has also made matters worse for emerging markets, given the sharp rise in leverage in their domestic economies since 2010.
The Fed continues to maintain that it sets monetary policy for its own domestic economy.
However, increased global inter-linkages (both financial and trade) coupled with the importance of the dollar as the main borrowing currency means, the ongoing differentiation between the US and the rest of the world has added a very important dimension to Fed’s monetary policy setting.
Indeed, we think that even if the Fed decides to initiate the hiking cycle in coming days or months, it will find it hard to sustain the path given the wide-spread signs of global disinflation which we believe argue for further global monetary easing not less.