The IMF added its voice last week to the chorus of Keynesians calling for Janet Yellen to – to paraphrase Rocky Horror – can it, Janet. The “it” being, of course, a hike in interest rates. The IMF cited “substantial output gaps” and “below target inflation” to justify their call for monetary policy to remain “accommodative”. I have no idea whether there is an output gap since my Potential GDP meter seems to be on the fritz but inflation is indeed hard to find. In fact, from my perspective, deflation seems more likely than its opposite, at least for now. So, I’d have to agree with the IMF (never thought I’d write that phrase) that Yellen should not adjust interest rates this week. Of course, that would be my advice all the time; the Fed shouldn’t be in the business of trying to fix prices in the bond market.
The IMF is viewing the global economy through its institutional eyes and what they see is an emerging world spinning out of control. The mere anticipation of higher rates in the US has pushed emerging market economies to the brink, currencies falling, inflation rising and growth waning. Combined with the slowdown in China – not completely unrelated by the way – the emerging world is getting whacked from all over. I think the IMF’s fear is that once the Fed makes that first move, the market will start pricing in further moves leading to another emerging market crisis. For the IMF that is bad news since they are the ones most often called upon to clean up such messes.
What is interesting about the IMF statement though is not their call for easy money; that’s to be expected from an institution literally created by Keynes. No, what is interesting is that they believe that policy is already accommodative – they called for policy to remain that way. That belief is hard to square with current market conditions. Low interest rates are not an indication of easy money but rather evidence of the opposite. If monetary policy was “accommodative” long term interest rates would be higher, commodity prices would be higher and the broad dollar index would not be sitting near an all time high. That has always been the contradiction at the heart of interest rate targeting. Easing policy requires the Fed to lower interest rates but evidence of the policy’s effectiveness is higher interest rates. No wonder monetary policy is confusing.
The problem the Fed faces is that they have told the world that setting policy today requires that they know something about the economy of tomorrow. And so their view of the economy, especially their projections, becomes all important and market moving. Markets move based on changes in the Fed’s expectations about the economy. And those market movements affect the Fed’s outlook and expectations which in turn move markets and so on and so on. With the Fed’s forecasting track record is it any wonder that markets have become more volatile?
I don’t know where interest rates should be right now but neither does the Fed or the IMF or anyone else. I also don’t know what the Fed will do at this week’s meeting but markets appear to have discounted a big part of any rate hike already. Inflation expectations are falling and the broad dollar index is nearing its 2002 high. The TIPS market shows weak real growth expectations. The Fed has spent so long talking about hiking rates that the market has moved ahead, acting as if policy has already been tightened. As I’ve said numerous times recently, expectations about policy have become de facto policy.
It may be that doing nothing provokes more market movement than going ahead with the rate hike. Markets are set for a move and if they don’t get it, we may see some violent moves. That doesn’t mean, by the way, that stocks will fall. Indeed, maybe the opposite. If standing pat moves the dollar lower and commodity prices higher, we may well see the S&P 500 move up rather quickly. It is the energy sector, so sensitive to movements in the dollar, that has been the main culprit in the correction (not the only one by any means but certainly the worst performing sector over the last quarter). If the Fed does nothing and the dollar falls, energy and materials stocks will probably lead the market higher.
I would think though that if that happens, one should be selling into the strength. The downside to the Fed standing pat is that it means they see the economy as so fragile that even a 1/4 point hike in interest rates is too much. What does that say about the effectiveness of recent monetary policy today if all these years of zero rates and all these iterations of QE aren’t enough to even get rates off the zero bound? Nothing good I’d say. I have often wondered what would happen when the public figures out the Fed emperor has no clothes. We may be about to find out.
I continue to believe that we’ve started a bear market, that this will turn out to be more than a mere correction. But conditions in the short term seem to favor a rally in stocks and the Fed deferring the hike seems the most likely catalyst. I don’t think it will change the economic outcome though. If our economy is so sensitive to rates that movements of a mere .25% are enough to put us in or keep us out of recession, then monetary policy is just an accident waiting to happen. The idea that Yellen or anyone else can fine tune interest rates to that degree borders on – no, is – ridiculous.
I think what would be most helpful for the economy right now is for the focus to come off the Fed. They’ve become the tail wagging the dog and have themselves become an impediment to growth. Way too much energy is wasted trying to figure out what the Fed is going to do, parsing every speech and statement of Yellen and all the other Fed members. The best possible policy announcement after the FOMC meeting next week would be a gag order. We’d all be better off if Janet and the rest of the Fed crew just shut up and danced the Time Warp. Damn it.
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