by Mohamed El-Erian, op-ed via The FT,
In hiking rates and, more notably, reaffirming its forward policy guidance and setting out plans for the phased contraction of its balance sheet, the Federal Reserve signalled last week that it has become less data dependent and more emboldened to normalise monetary policy. Yet, judging from asset prices, markets are failing to internalise sufficiently the shift in the policy regime. Should this discrepancy prevail in the months to come, the Fed could well be forced into the type of policy tightening process that could prove quite unpleasant for markets.
Setting aside multiple signs of an economic soft patch and sluggish inflation, the Federal Reserve did three things on Wednesday that lessen monetary stimulus, only the first of which was widely expected by markets: It raised interest rates by 25 basis points, reiterated its intention to hike four more times between now and the end of next year (including one in the remainder of 2017), and set out a timetable for reducing its $4.5bn balance sheet.
These three actions confirm an evolution in the Fed’s policy stance away from looking for excuses to maintain a highly accommodative monetary policy — a dovish inclination that dominated for much of the aftermath of the 2008 global financial crisis. Rather, the Fed is now more intent on gradually normalising both its interest rate structure and its balance sheet. As such, it is more willing to “look through” weak growth and inflation data.
This evolution started to be visible in March when Fed officials worked hard, and successively, to aggressively manage upwards expectations that were placing the probability of an imminent rate hike at less than 30 per cent. With that, the hike that followed was an orderly one.
Yet, judging from market developments — including an implied probability of around 50 per cent for another hike this year and a generalised yield compression — traders and investors are resisting the Fed’s re-affirmed forward guidance. Instead, they are betting on the repeat of the past few years during which officials have tended to over-estimate the extent of policy tightening and, in subsequently reversing course, have converged back to the lower rate path implied by markets.
This time round, however, such questioning is more dubious given the evolution in the Fed’s policy regime. But it need not necessarily end in tears.
Maybe, just maybe, central bankers have a credible positive feel for what, until now, has been an unusually sluggish response on the part of productivity, wages and inflation. As such, they are confident that growth will pick up and that inflation will converge rapidly to their 2 per cent target.
Maybe they have better reason to believe that, working with Congress, the Trump administration will be able to deliver on pro-growth policies in the next few months. Or, maybe, they see comforting signs of a stronger global reflation that others are missing.
While hopeful, these are unlikely to be the main reasons for the current discrepancy between the Fed and markets. More likely, the central bank is now focusing more on excessive risk-taking by investors and traders, including its potential negative impact on the economy down the road.
In yet another unusual twist, the latest Fed rate hikes were accompanied by a loosening, not tightening, of financial conditions. But rather than lead to higher economic activity and inflation, this has fuelled even more exuberant risk-taking, with stocks and corporate bonds decoupling further from economic and corporate fundamentals. The longer this continues, the greater the risk of a sudden sharp market correction that could damp both consumption and investment.
Markets would be well advised to pay closer attention to the forward guidance. This is an evolving Fed that, absent a major economic downturn, will maintain a more hawkish tilt to monetary policy. And, while it is well ahead of others, it is not the only central bank undergoing such a transition. The Bank of England is also itching to tighten policies despite a weakening economy and Brexit uncertainties, and the European Central Bank may soon be compelled to follow.
The longer markets discard the Fed’s reconfirmed policy guidance, the greater the potential for asset markets to be disappointed by a central banking community that is shifting from being best friend to becoming a lot less supportive.
And should the Fed be proven wrong by a significant slowdown in the economy, markets would have little to cheer on that account too given the extent of the recent liquidity-driven rally…
