On July 26, Janet Yellen, and her colleagues on the Federal Open Market Committee, gazed into their crystal balls and saw the future, well more accurately, the US economic future. They saw a labour market that continued to strengthen. They saw economic activity rising moderately and solid job gains. They even saw household spending and business investment expanding.
But they didn’t see inflation rising. In fact, the quadrant of the crystal ball reserved to anticipate CPI gains, was as empty as it had been all year. That was problematic for a Committee that alluded to three rate increases in 2017.
They didn’t get spooked, or even startled but they got cautious and expressed the caution in that uniquely central banker way.
They issued a vague statement with minor changes from the previous one and let the market draw its own conclusions.
That way, they could explain whatever occurs in the future, using the words of former Fed Chair Alan Greenspan. He famously said: “I know you think you understand what you thought I said but I’m not sure you realize that what you heard is not what I meant.”
The June 14 FOMC statement would have received a C+ from Mr. Greenspan. It said this about inflation: “On a 12-month basis, inflation has declined recently and, like the measure excluding food and energy prices, is running somewhat below 2 percent.”
The wording for this same phrase in the July 26 statement merely replaced “running somewhat” with “are running.”
It is a barely perceptible tweak but it caused a reaction to rival the annual Pamplona Encierro.
The US dollar was sold against the major currencies with many traders muttering “If I had only known.”
That lament is spoken thousands of times a day around the globe. “If I had only known, I wouldn’t have shorted Amazon’s IPO.” “If I had only known, I would have voted for Hillary,” or more recently, “if I had only known I wouldn’t have sold all my Canadian dollar for US dollars in January.”
On Wednesday cries of “If I had only known the Fed would get spooked by inflation, again” were made by traders unleashing a wave of US dollar selling.
Yet, what is the bigger threat to FX market- low inflation rates which are already priced in to current prices or the onset of balance sheet normalization?
The FOMC appeared to move forward its plans to begin balance sheet normalization. In June, they said “this year” and on July 26, changed it to “relatively soon.” To many analysts, it means details will be announced at the September meeting.
The Fed and other central banks have a long and practical history of managing inflation. Not so with balance sheet normalization.
Ben Bernanke, another former Fed Chair wrote: ”if the shrinkage of the balance sheet is passive and predictable, the risk of market disruption is minimized.” He also warned that “since the effect on broader financial conditions is uncertain the process shouldn’t begin until interest rates are comfortably away from their effective lower bound.”
That premise raises a two-fold question: “Are US rates, at 1.25 percent, comfortably away from zero?” and “What effect will balance sheet normalization have on near term financial conditions and market sentiment?”
No one knows the answer, but black swans have been seen paddling in the Potomac River.
There are other factors at work. The Fed and US policies have major ramifications across the globe. An Institute of International Finance (IIF) study suggests that the Fed’s plan not to replace maturing bonds will trim $200 billion from its balance sheet.
The IIF argues that a mere $65.0 billion reduction in the Fed’s balance sheet would equate to a $6.5-$7.0 billion drop in emerging market portfolio flows or the equivalent of a 0.25 bps Fed rate hike. Therefore, a $200 billion decline would be like three rate hikes.
Still, it’s just a guess (an educated one, at that). The key takeaway is that events in emerging market economies have a nasty habit of disrupting developed market economies.
If the FOMC crystal ball gazing has a hard time discerning the direction of inflation, why should global financial markets believe that their balance sheet unwinding plan will unfold without any problems? Only time will tell.
