Fed Governors’ speeches – bias to tighten in Dec

The publication of yesterday’s speeches from Fed Governors Bullard, Evans, Fischer and Lacker provided a useful real-time sample of the current thinking at the FOMC. In our view, despite a clearly dovish speech from Charles Evans, the more hawkish tone of October’s FOMC statement was only reinforced. This may have triggered the sell-off in commodities and equities towards the end of the day and reinforces our view that the Fed is not bluffing on a rate increase in December, absent a major market decline.

James Bullard, who is not a voting member of the FOMC but is on record as believing that US rates should rise, focused on the difference between the short-and medium-term effects on inflation of ultra-low US interest rates. Based on the stylised models he presented, the US economy would appear to be well past the 2-1/2 year point where ultra-low rates are stimulating the economy; instead they may be contributing to the absence of inflationary pressure. While we do not necessarily share his views on the mechanism we would concur that the extended period of low rates may now be contributing to deflationary pressures. The example of the mining and energy sectors where additional debt-financed and high-cost capacity has contributed to a deflationary environment would seem clear enough. There was little for the doves in this speech; this was a call not only to raise rates now but also to think more conceptually about whether low rates are in fact causing the observed low inflation.

Stanley Fischer’s contribution to the debate centred on the effects of the strong dollar on the US economy. Drawing the distinction between a small open economy and the US he highlighted a Fed staff model which, for a 10% increase in the broad US dollar index, suggested a drag of 1-1/2% of GDP would be likely to be felt over the medium-term from the impact on net exports. This FX drag on GDP assumed the absence of an offsetting monetary policy response. But he also made clear in his view that the US had weathered the US dollar appreciation well, at least in part due to the FOMC’s prior decision to defer raising rates during 2015. By highlighting the FOMC discussion on raising US rates due to take place in December and avoiding any discussion on the ‘blowback’ that dislocations in emerging markets may have on the US economy we would suggest Fischer’s bias now is to tighten, even if he voted for no rate increase during October.

Charles Evan’s speech was by far the most dovish of the day. Entitled “A cautious approach to monetary policy normalisation” he emphasised the downside risks to the inflation outlook. While acknowledging the recent declines in the unemployment rate to 5.0% (the Fed’s estimate of the long-run sustainable rate is 4.9%) he highlighted other measures of labour market slack such as the rise in part-time jobs, weak wage growth and low labour force participation rate. In respect of the downside risks to inflation he takes a wholly different tack to James Bullard; the lack of evidence of inflationary pressures mean a later liftoff and slower pace of monetary tightening will best position the US economy in his view. This voting member of the FOMC seems unlikely to vote for a rate increase in December and is also likely to push hard for communications which emphasise a measured pace of rate increases once lift-off occurs.

Jeffrey Lacker, who at the most recent FOMC meeting voted for a rate increase, took a strong position on the limitations of monetary policy. In his view, monetary policy can effectively control the rate of inflation but cannot change medium-term economic outcomes as population and productivity growth are the dominant factors. Furthermore, he believes central banks should be even more cautious about using monetary policy to achieve financial stability. With comments suggesting that today’s low inflation rate could even be a largely random event which should not imply a longer-term deviation from target, as expected this was a very hawkish but well argued speech.

In our view what was left out of these speeches was any meaningful discussion on the second-order effects on the US of a slowdown in global activity in a period of increasing US interest rates. Focusing on the US in isolation will naturally lead the FOMC to a more hawkish conclusion. Taken as a sample of current FOMC thinking, only one out of the four speakers said anything in favour of not raising rates at December’s meeting.