“They’re getting more worried about the negative consequences of QE”: Fitch Chief Economist
The markets have been brushing off the Fed and have done the opposite of what the Fed has set out to accomplish. The Fed wants to tighten financial conditions. It’s worried about asset prices. It’s worried that these inflated assets which are used as collateral by the banks, pose a danger to financial stability. It has mentioned several inflated asset classes by name, including commercial real estate, which backs $4 trillion in loans heavily concentrated at regional banks.
And yet, markets have loosened financial conditions since the Fed started its tightening cycle in earnest last December. Markets are hiding behind “low” inflation, when the Fed is focused on asset prices.
So longer-term yields have been falling even as short-term yields have moved up in line with the Fed’s target rate, and thus the yield curve has flattened. The dollar has been falling. Equities have been soaring to new highs. And companies, if they’re big enough, are able to get funding for the riskiest projects at stunningly low rates.
“I think there is maybe too much confidence that the Fed is not really going to do too much more on interest rates, that we’ll have one or two more rate hikes and that’s it,” Brian Coulton, chief economist for Fitch Ratings, told Reuters on Tuesday.
Market participants are expecting “just one or two interest rate increases a year” despite the Fed’s stated expectation of seeing long-run interest rates at around 3.0%.
“When the Fed says they’re going to engage in a gradual rate of interest rate increases, they mean three or four rate hikes every year and we think that’s what they’re going to do,” Coulton said. “We think that you should take them at their word and it may even be a little faster than that.”
This disconnect between market expectations and the Fed’s stated intentions could create volatility in fixed-income markets when markets finally catch up, he said.
Volatility, when it’s used in this sense, always means downward volatility: a sudden downward adjustment in prices and spiking yields – a painful experience for the coddled bond market with big consequences for the stock market.
“We think they’re going to be … getting more worried about some of the negative consequences of QE, the fact that it encourages risk taking and may create some issues for the banks,” he said.
And he expects – this is “more of a personal view,” he said – that the Fed will continue with the rate hikes, or even accelerate them, even if consumer price inflation remains low.
Despite “low” consumer price inflation – which is in the eye of the beholder – the Fed has raised rates four times since December 2015, including three times over the past nine months. Before the rate hikes began, the Fed’s target range for the federal funds rate was 0% to 0.25%. Now it’s 1.0%-1.25%.
Federal funds futures are expecting just one more rate hike by August 2018. And as the Fed moves forward, it might trigger a sudden adjustment in yields as markets catch up with the Fed.
The Fed has caused this disconnect on its own. Starting in 2013, it has engaged in relentless mind-numbing flip-flopping, first on tapering of QE – the subsequent Taper Tantrum in the bond market caused furious flip-flopping – and then on raising its target for the fed funds rate. In an astounding cacophony, Fed heads have publicly disagreed with each other and their own prior statements. At every squiggle of the markets, perhaps worried about their own portfolios, they flip-flopped from prior communications of their intentions.
During this period, they took their credibility out the back and shot it. And when that credibility seemed to still have any life left in it, they shot it again. And even after everyone saw that it obviously had no more life left in it, they shot it again, just to make sure.
Now no one believes them anymore. It’s hard to revive a credibility with so many holes in it. But that’s what the Fed is trying to do. And since December, it has been sticking to its story with a focus on asset prices, the chase for yield, the banks, and financial stability – essentially brushing off a bout of “low” consumer price inflation.
Next up is the well-telegraphed announcement at the September 19-20 meeting to unwind QE. The amounts and the mechanics have already been announced. Now it’s just a matter of announcing a start date. If they stick to it, it’s one more move – a huge move – in their efforts to revive their credibility.
But reviving credibility, after it has been so thoroughly shot so many times, will take years. No one will easily forget the endless flip-flopping between 2013 and mid-2016 that made laughingstock out of these people. Now markets keep expecting the Fed to flip-flop all over again. But since the fall of 2016, it hasn’t. And markets are not prepared for a non-flip-flop Fed.
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