Yesterday’s highly anticipated release of the Federal Reserve minutes of last month’s policy-making meeting did little to answer decisively the question on the minds of many market participants: whether the Fed will raise interest rates in September, the first increase in more than nine years. The minutes didn’t necessarily reflect a Fed that wishes to keep its cards close to its chest. Instead, they were an indication of the analytical complexity of the situation facing the central bank.
The Fed’s countdown
There are four notable factors that are proving very confusing for Fed officials and, accordingly, led them to keep their policy options wide open – that is, neither commit to a rate hike or take it off the table for next month:
First, the signals from the U.S. economy are at odds with those from international markets: While far from unambiguous, especially given the weakness in inflation and wages, U.S. economic readings tend to support a Fed rate hike as early as next month. But this isn’t the case for the international data. Whether it’s Europe and Japan or emerging markets, the numbers there clearly point to a weakening global economy and, accordingly, would suggest more policy caution.
Second, the fragility of financial markets: The last few weeks have seen notable weakness in a growing number of areas. What started out as relatively localized disruptions in the oil market and emerging-market currencies have spread – first placing pressure on corporate bonds and more recently on equities.
Third, the extent to which the U.S. economy’s behavior hasn’t adhered to Fed models: The inaccuracy of Fed projections is bound to raise questions in the minds of central bank officials as to the robustness of their understanding of economic developments. The broader these questions are and the longer they persist, the more risk averse Fed officials would be in embarking on a change in rate policy.
Fourth, the divergence in central bank policies: The Fed’s deliberations on tightening stand in stark contrast to the stimulative stance that other central banks are pursuing. This difference will probably intensify, particularly for the European Central Bank, the Bank of Japan and the People’s Bank of China. Another consideration: China’s currency devaluation last week has put pressure on many emerging-market currencies, making U.S. central bankers uncomfortable about the risk of a rate increase that strengthens the dollar. That could compromise U.S. exporter’s ability to compete and undermine the country’s economic lift-off.
All in all, the Fed had no choice but to once again come across as wishy-washy – not so surprising given the extent of uncertainty with which it’s dealing. As such, it will remain noncommittal until the very last moment before its September policy meeting. And, in order to ensure its options are wide open, it will also double up on efforts to divert market attention away from the timing of the first hike and in favor of three elements that would characterize this cycle of impending rate increases, which I like to call the loosest tightening in Fed history: a very shallow path for future hikes, a decision-making process that remains highly data-dependent and a ceiling for policy rates that is below the historical average.
