The Business of Anchoring Expectations

How much would you rely on the Fed put? From James Saft in his Reuters column,

Investors will be hoping for confirmation of the “Fed put,” the concept that it will ease conditions when investors face losses and volatility. Worries about slow growth and debt in China, as well as slowing global trade, have hit global financial markets hard, sending U.S. stocks to their worst January ever, down 7 percent.

In his article, he quotes Jim O’Sullivan of High Frequency Economics, “Officials will probably want to acknowledge the extra uncertainty raised by recent ‘financial and international developments,’ but they will likely also want to avoid encouraging the perception that a relatively modest bout of risk aversion in markets or mixed signals from the data will promptly change their outlook in a major way.”

James Saft writes that in light of relatively stable domestic financial conditions in the U.S. where loans are still inexpensive, it will be hard for the Fed to make a case for more caution. Having noted the point with regards to domestic conditions, perhaps Mr Saft should also look at the softening in consumer consumption and rising savings as shown by this chart:

consumersjan2016

A strong enough negative wealth effect may just be the reason that a dovish Yellen needs, should she need it.

To continue, Saft proposes that what we are likely to see from the Fed are two things; “One, an acknowledgement of the international situation and secondly, a nod to declining inflation expectations.”

In a previous post, I wrote that:

But really, it’s about:

  • establishing the credibility of the Fed’s communication,
  • convincing the public of the methodology of Fed decisions moving forward,
  • and whether or not the market can reliably depend on those decisions to derive their own decisions.

For the market to have confidence in the Fed’s decisions, the market needs to believe that the Fed can produce good  forecasts of the economy.

Yellen has mentioned that the assessment will not only take into account labour and inflation figures (obviously), but also give consideration to financial and international developments. Just a few months ago, the market was somewhat surprised when China was included as a factor.

With regards to China, James Saft writes,

There is both justification and danger in the Fed citing China as pretext for caution about interest rates. Surely ebbing Chinese demand is helping to suppress commodity prices, dealing difficulty to emerging market economies and those who mine and drill. That’s a real negative for global and U.S. growth.

Yet China is a problem which is highly unlikely to be resolved anytime soon, both in terms of its market stability or its long-term transition to domestic consumption, so if the Fed talks about “global” issues too much it somewhat takes its own initiative away.

China would have its problems for many years yet. However, using the same reasoning as a tool for impact will become dull after a few uses. Regardless of the reasons, be they domestic softening or China’s downturn, the main issue is that the Fed has the world’s economy on tenterhooks.

Roger Blitz in the FT  too, seems to agree with the view that the market, other countries’ policy makers, butchers, bakers and candlestick-makers all now have their ears tuned into Yellen,

Central banks have begun the year dancing to a Duke Ellington classic. Imagine US Federal Reserve chair Janet Yellen crooning “Do Nothing Till You Hear From Me”, and a host of governors, from Mario Draghi to Mark Carney, dutifully obeying.

Because until Ms Yellen and her colleagues have their say this week on oil, China and whatever other factors are contributing to 2016’s frantic start in the markets, policymakers’ best — and probably only — course of action around the world is, indeed, to do zip.

That might mean a loss of face for some central banks, such as Brazil and Canada that had primed the market to expect rate movement, yet which last week kept rates unchanged.

With the conclusion,

Of course, the dollar’s strength may be tested if support returns for emerging market currencies, if China data improves consistently or if oil enjoys a sustained rebound.

Short of those turnrounds, the dollar is “the only place you want to be”, says Mr Karydakis. But if investors want further evidence, they should do nothing till they at least hear from the Fed.

If both of these writers’ view is correct, that we are all anchoring expectations on Fed announcements, then this tells me three things:

One, that the Fed has been successful in its endeavour to anchor expectations (stemming from the building and retaining of its credibility),

Two, spillovers from the Fed monetary policies have a bigger impact globally on capital flows, currencies, spreads and other investment decisions  than is currently realised, and

Three, if Fed communications are becoming such a significant consideration, so much so that we do nothing until the announcements, the communications will become a common factor in future investment models alongside other macro factors. Or even worse, not just become a proxy for fundamentals but overcome the importance of fundamentals.

That, is not a good thing.

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