In April of last year, the market didn’t seem to be picking up on fairly heavy Fed hints about its thinking, so I wrote a quick post entitled Avalanche Patrol. This morning a friend asked me if I’d update the concept. Given that we just hit another patch where the market was again caught out shrugging off fairly heavy Fed hints, I though I would take a sec and post my response.
The biggest variable that’s changed is ‘remaining slack’ in labor market is now a live debate in a way it wasn’t in April of 2015. The uptick in wage growth, while low relative to the impulse we’ve received from job growth, is real.
However, the main reason many of the members are antsy to get off of war footing is still the understanding that financial stability risks are a positive function of time. I don’t think they believe there are systemically significant areas of excess in the US at present. They just want to stay out in front of that risk as best they can this time around. We’re not the only ones suffering from PTSD.
In short, they need/want to hike ASAP in their minds but know they can only do it when there is a very, very low probability of having to reverse later. And the Fed knows there are still questions about slack, whether inflation will come back as much as they hope post-oil stability, and weakness/potential instability in the global economy.
The final thing that some on the Fed are mindful of is that the level of policy rates (within reason) is not as much a deterrent to leveraged financial risk-taking as uncertainty about the path (Just compare the risk-taking in 2005-06 with Fed Funds at 5% relative to post GFC with rates at zero). I’m not sure the freshwater guys get this; they tend to focus more on the level of rates, because that’s what theory has pounded into our heads for the past 25 years.
So, with the above, what would you do in their shoes? I know what I would do: In my talk, err on the side of hawkishness to signal my intent; in my actions, err on the side of dovishness until the issues of slack and oil price drop out become less ambiguous; and, finally, keep market participants from getting complacent with Fed path and don’t let them run too far with errant narratives (which can feed on themselves),
Market guys, old school economists, and free marketeers won’t like any of this. They still believe-despite all evidence to the contrary–that markets are mostly efficient and self-equilibrating, and that bubbles are caused by bad US government policy (ignoring the global nature of the GFC). But reality disagrees, and the Fed has to deal with our new reality. And this does complicate their mandate considerably.