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"Policy Mistake"

When it comes to the Fed's current "data dependent" thinking and what it may or may not do in the coming months, there is absolutely no agreement among the experts: it may or may not hike in December, or it may or may not hike in the 2016 election year.

There is, however, agreement on two things: its recent "communication policy" has been a total disaster as Pedro da Costa explained recently from his new perch at Foreign Policy magazine; and when looking at the corner the Fed has painted itself into, the consensus is summarized with two simple words: "policy mistake", as the

showing the appearance of these two words in Bloomberg news stories confirms.

 

And here is BNP with the best explanation why:

The market took the FOMC statement as hawkish. There were two key reasons:

  1. The first was removing “recent global and financial developments may restrain economic activity somewhat and are likely to put further downward pressure on inflation in the near term”.
  2. The second was saying, “in determining whether it will be appropriate to raise the target range at its next meeting, the Committee will assess progress – both realized and expected – towards its objective of maximum employment and 2 percent inflation.”

The way we read the first change is that Chair Yellen overplayed the China card in the last press conference and that the events referred to in September are no longer ‘recent”, not that global developments are not significant, since the Fed is still “monitoring global economic and financial developments.”

The second is a clear attempt to stop the market from pricing out December (eg, in response to soft GDP data tomorrow, which the Fed will have had in hand for Wednesday’s meeting) in case the weak recent payrolls look to be a flash-in-the-pan. Our assessment is that December is still not likely (our subjective probability climbed back up to 35%). The Fed has given it an adrenalin shot to keep December’s hopes going, but the patient‘s chances look far from promising, since the vital signs in the economy are fading.

What the market ignored was that the Fed no longer says growth “is” expanding at a moderate pace, but that it “has been”. Clearly the message is things have changed. The assessment of the labor market was also revised down.

The Fed wants us to believe that it did not go in June and September, when the economy had a stronger pulse than it does now, but it is really seriously considering December. So much for data dependence. To us, this seems to compound the Fed’s recent communication challenges and also threatens to combine this with a serious policy mistake. We don’t believe Chair Yellen will go along with this in the end, but the probability of a mis-step seems to have risen, to roughly a 50% chance in the market’s eyes.

The shift in wording to a more hawkish stance, when the data have softened, carries dangers for a Fed already criticized for its communication policy. If the incoming data are half decent (say payrolls 40,000 or so better in October than September) the Fed may have painted itself into a corner, where it has to hike or its credibility is severely damaged, even though the broader data are weakening. This would only make sense if the Fed was convinced the recent economic weakness was truly transitory. Alternatively, it may be the Fed thinks “it’s now or never” and sees the danger of a prolonged soft patch that could lock it out for a considerable period – maybe until we are uncomfortably close to the presidential election.