13 March 2018, 10:28 GMT
Many investors have been surprised by the Federal Reserve’s hawkish shift in tone over the past few weeks. Perhaps the most interesting comments, however, have come from Lael Brainard, one of the Fed Governors usually at the dovish end of the spectrum. Brainard is often seen as a bellwether, and her recent speech to New York University is a perfect example of her performing that role. In it, Brainard gives greater clarity on the surprising shift from the Fed’s relative caution to more determined hawkishness.
It’s enlightening to contrast this speech with one Brainard gave just six months ago. Both speeches ultimately prescribe the same thing, namely ‘gradual increases in the federal funds rate’. What has changed, is the bias around that prescription, and the framework that Brainard — and likely the Fed at large — is choosing to adopt.
This bias has changed from concern over low inflation, to being ready to adjust ‘policy in either direction’. Back in September, Brainard was arguing that the Fed might have to raise interest rates more gradually than its ‘base case’. Fast forward six months, and Brainard is arguing that there might be a need for monetary policy to become more aggressive. There are various reasons for this change of heart, including looser financial conditions, a weaker dollar and upwards revisions to global growth. However, all of these factors were already there in September, suggesting that the Fed has decided to be more hawkish than it particularly needs to be.
This implies that the framework for monetary policy is the key difference for Brainard and the Fed versus six months ago. The idea of a persistently low - maybe zero - ‘neutral’ real rate has totally disappeared. This is a big deal, along with the doves also seeming to drop their argument that balance sheet run-off equals fewer hikes.
Worries over low inflation, which have arguably held the Fed back over much of the past two years, are also diminishing —rightly or wrongly. Brainard now says that "stronger tailwinds may help re-anchor inflation expectations at the symmetric 2% target". There is less concern that the Philips Curve is broken. Existential doubt in the Fed’s ability to move inflation up is replaced with a renewed faith that strong growth will boost inflation, despite no data really backing that up yet. Essentially, it’s the hakuna matata approach to central banking, versus the data-dependence of recent years.
Brainard’s speech, together with comments from other speakers, make it less likely that the Fed will be knocked off its tightening path. The Board seems prepared to raise rates above 2%, even without core PCE rising above target, and will read incoming data on inflation as ‘glass half-full’. That opens the door to four rate rises this year. We might see a shift in the dots as soon as March — in addition to ongoing ‘quantitative tightening’ (balance sheet reduction).
It’s perhaps too early to judge the market implications of this yet. Marginally tighter monetary policy might not be enough to turn around weakness in the US dollar given the strong global picture and a widening trade deficit, but it could provide something of a floor. What seems worryingly likely, is that this all leads to risk markets challenging the Fed with a deeper sell-off at some point later this year. I think the Fed would pause in this environment — it’s easy to talk tough when almost nothing has gone wrong for nearly two years, but this hawkish rhetoric has simply not been tested.
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