Last year when the Federal Reserve finally pulled the trigger on tapering, beginning to end its massive bond buying program (QE3), the markets and so-called experts—once they realized tapering was not tightening (a massive yearlong effort in its own right)—speculated as to when the Fed would actually tighten monetary policy.
Despite the wave of speculation and analysis, there has been a pretty solid consensus around mid-2015 give or take a quarter. One thing that seems to be clear, as with the Fed’s tapering decision, is that it has taken longer than originally anticipated so that the Fed does not want to have to turn back once initiating a new policy. So caution is the watch word.
Sheryl King, Senior Director of Research for Roubini Global Economics says, “This has been an area of research and soul searching. We’ve come through our numbers and continue to think the economy is reasonably well shielded from the downturns we started to experience in global growth and more we expect is on the way. We still think that the Federal Reserve is going to be on track to raise interest rates at some point in 2015. [We anticipate] the first increase will be in the third quarter.”
The third quarter is a safe bet squarely in the middle of the consensus. Gibson Smith, chief investment officer for fixed income of Janus Capital Group, says the Fed may have cover to wait longer, though adds that there is room on either side of the consensus.
“Our view has been that the Fed has been forced into a position to be on hold for longer than the market is anticipating and longer than what has been priced into the market,” Smith says, “but I do think that there are a couple of wild cards out there that can change that view in the short term.”
The wildcards he mentioned are the precipitous drop in crude oil prices (see “Crude oil and the economic cycle,” here) and the suddenly robust jobs sector.
We spoke to Smith after the November jobs report showed a 321K increase in nonfarm payrolls. “The important component being the average hourly earnings number going up 0.4% and showing a 2.1% year-over-year rate, an indication that the labor market is on much firmer ground than the market thinks,” Smith says. “Secondarily there is a lot of talk about what is happening in the energy markets. The move in [crude] oil from $115 down to 68 is a stimulative event.”
The move in crude is an interesting wildcard as it can be viewed in two ways. Some analysts see it as giving the Fed more room because lower prices may reduce the risk of inflation. Smith has a different take. “The markets in many ways are forgetting the importance of energy as a tax or as a stimulant to disposable income. These are two wild cards that could force the Fed’s hand a little earlier than the Market is anticipating,” he adds.
Wildcards aside, there is a history of postponing the exit from extraordinary stimulus. “From talking to Fed officials and reading what Fed officials are saying to us, they don’t want to ever be in the position that Japan faced in the 1990s where they misread the signals that the economy was telling them and started to raise interest rates only to have to back off when the economy tipped back into recession after a mild tightening,” King says. “This is something that we’ve seen repeated around the world. Many [central banks] have raised interest rates and been forced to back off. They have been reversing course because the global economy and subsequent impact on their economy told them they were not ready for higher interest rates. That is the last thing that the Fed wants to do.”
Smith points out that the Fed is focused on growth and inflation. “The inflation data has been contained and we know what is happening [globally], deflation. Net net the Fed is going to be in a difficult position of having to make decisions around what is happening domestically as well as what is happening globally,” Smith says. “Japan is in the process of a major restructuring with Abenomics, the USD/JPY hit 121.50 this morning. Europe is in a deep recession and the divergence in the economic output in the periphery vs. Germany is getting a lot of attention and that becomes an issue for global growth.”
But the Fed cannot operate in a vacuum. Just as the U.S. economy is giving the all clear in terms of a policy shift, the rest of the world appears to be heading in the opposite direction.
“The Fed has to think in two veins; one, what is happening domestically and the implications of their moves on the global situation,” Smith says. “That is why the Chinese policy move [in late November] and what I think will be additional moves are very important. As a percentage of global GDP, China and the United States are important. “
However, not everyone sees Eurozone and Chinese weakness as a complication for the Fed. “In one respect it is actually helping them because it is less of a drag on the export sector,” King says. “The other aspect is the impact on the U.S. dollar as the interest rate differentials pull away from each other. The ECB policy actions are going to get more stimulative. They have been calling for QE, [which] is looking like it is going to be a Q1 event. So they are going to be expanding their balance sheet by $1 trillion, the Bank of Japan is going to continue with their policy stimulus which will mean more downward pressure on the yen. The yen will rise to 128 vs. the U.S. dollar and the euro will go to 115 by the end of next year. Even some emerging market countries will see some depreciation.”
King expects the trade weighted U.S. dollar, the value of USD vs. a basket of currencies, is going to appreciate 4-6% over the next two years, in addition to the 6% we have already seen.