In textbook fashion, the Federal Reserve has prepared traders and investors for a 25 basis points increase in policy interest rates this week. When it comes to lasting effects on markets, however, the Fed is likely to deliver more than the third rise in 10 years. It will also signal an important evolution in its policy approach aiming for a beautiful rate normalisation.
Facing an implied probability of a March Fed increase of about 30 per cent just two weeks ago, the Fed guided market expectations higher — whether by luck or through skilful design. A trial balloon in the form of hawkish signals by the presidents of two regional banks (Dallas and San Francisco) was amplified by the comments of New York Fed president Bill Dudley and US Fed board governor Lael Brainard, and they all culminated in validating remarks by US Fed chair Janet Yellen and her vice-chairman Stanley Fischer. As a result, the Fed is now set to raise rates with the implied market probability near 100 per cent.
The question for markets is no longer whether the Fed will raise rates this week; it will. It is about official signals regarding the future rate path, and what that means for asset prices that have benefited handsomely from the prolonged implementation of unconventional monetary policy stimulus.
Going with the tide of reflationary data, including Friday’s blockbuster job creation and slightly higher wages, the Fed is likely to encourage markets to embrace a policy regime shift that — critically — is gradual, orderly and retains optionality.
The repeated reaffirmation of a 2017 baseline of three rises would initially anchor the path of gradual rate normalisation. Down the road, this would be followed by suggestions that the balance of risk is tilting in favour of more, rather than fewer, increases (though the central bank will not rush to specify with confidence the terminal rate).
In embarking on this path, officials will be keen to minimise undue market volatility lest that act as a headwind to growth
In embarking on this path, officials will be keen to minimise undue market volatility lest that act as a headwind to growth. Close monitoring of orderly financial conditions would be accompanied by periodic reminders to markets that the central bank retains policy flexibility, particularly considering the “unusual uncertainty” affecting economies and politics in Europe and the US. It would reiterate that policy is far from being on autopilot, retaining optionality for midcourse corrections should they prove necessary.
In all this, the Fed would be transitioning from a highly tactical (“data dependent”) mindset towards a more strategic one; and it is one that enables it to more confidently (and assertively) lead markets rather than follow them. It is a change that would not be easily derailed by high frequency data but whose ultimate success — and, therefore, the lasting impact on markets — is a function of both domestic and international factors that it does not control.
On the internal front, the Fed needs to strike a delicate balance between the risk of a “Type 1” error of falling behind the curve — which would result if Donald Trump’s administration and Congress managed to deliver quickly on the pro-growth policy trifecta of tax reform, infrastructure and deregulation; and a “Type 2” error of a premature tightening process as a result of severe market instability, trade protectionism and/or the legacy of too many years of low and insufficiently inclusive growth (including anger politics and the undermining of productivity and other engines of sustainable growth).
To deliver a beautiful normalisation, the Fed also needs other countries to amplify their pro-growth policy efforts
International factors are also in play. To deliver a beautiful normalisation, the Fed also needs other countries to amplify their pro-growth policy efforts lest a stronger dollar trip up domestic activity, erode corporate profitability, amplify protectionist forces and fuel the gradual fragmentation of the international monetary construct.
Look for this week’s Federal Open Market Committee meeting to be remembered as constituting a serious attempt — the most serious so far — by the Fed to leave behind the “lower for longer” paradigm that has been a key part of its unconventional monetary policy. Success, however, is not something that the central bank can deliver on its own. Its wellbeing — and, more importantly, that of the economy and markets — requires that politicians in the US, Europe, Japan and China also step up to their economic governance responsibilities.
Mohamed El-Erian is chief economic adviser to Allianz and author of “The Only Game in Town”
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