There is a big fight going on in the US. But it is not the one you are thinking of. It is the one that is playing out between the US Federal Reserve (the Fed) and the markets. This tussle has been going on for some time, but it may come to a head this year - and the risk of defeat is greater for one side than the other.
The January statement by the Federal Open Market Committee did not deliver the knock-out punch, as there was no great change to sentiment. Generally, the big announcements come when a press conference accompanies the statement - and that only happens four times a year. On the whole, the statement was fairly balanced - neither as hawkish nor as dovish as the market response.
The Fed found three things it liked about the US and three things it did not like so much. It upgraded its view of the economy from “moderate” to “solid” and described the labour market as “strong” rather than “solid.” The Fed also took a favourable view of the decline in the oil price as a means of boosting household finances and therefore consumption in the economy.
On the negative side, the statement discussed some familiar topics that are casting a shadow on its interest rate policy: the fall in inflation and, more importantly, the significant fall in market expectations for future inflation. The Fed also mentioned “international developments,” which may have been a reference to some perceived weakness in the global economy or the strength of the US dollar. However, the Fed will be more concerned with what is happening in the domestic economy rather than the rest of the world.
This latest statement sends the signal that the Fed is not quite ready to move just yet, but may be closer to acting than the market thinks. It is similar to runners at the starting line: the starting pistol has not been fired, but the call for “on your marks” has gone up. The next clue will come when the Fed removes the word “patient” from its language. Looking at the Fed fund futures rates, which show market pricing for future short-term interest rates, markets are pushing out expectations for the timing of Fed rate hikes to well into the end of this year, or early 2016.
This week’s chart shows just how much time head of the Fed Janet Yellen spends in conveying her message to the market. At press conferences, she spends 50 per cent more time than previous governor Ben Bernanke on the opening statement and on answering press questions on policy decisions. The Fed’s message is actually pretty straightforward. It argues that the falling unemployment rate increases the likelihood that wages will start to rise. When combined with falling fuel prices, the economy could soon start to benefit from a consumption boost. If the economy continues to firm up in this way, it will not be long before inflation picks up and policy rates start to move higher.
This is all well and good, but the market is justified in doubting the Fed. There is little inflation in the economy right now, and it is likely to fall further given the rapid decline in oil prices; nor have wages increased in line with the rising employment level. What is more, over the first month of this year alone, 10 central banks have taken steps to ease monetary policy. This puts further upward pressure on the US dollar and represents a de facto tightening in monetary policy.
It is true that wage growth has been slow to materialise and that the increase in spending has not been as high as expected. But there are signs that this is starting to change, and even accelerate. The fourth-quarter GDP release showed a marked increase in personal consumption of 4.3 per cent, accounting for the bulk of the 2.6 per cent headline economic growth figure.
While not all the higher-frequency economic data is pointing in the right direction, GDP numbers suggest that the US economy is in pretty solid shape, with conclusive proof that consumers are dipping into their pockets to spend. This backdrop, coupled with a continued increase in wages, could lead to a summer rate hike by the Fed. The knock-out punch is still to come, but the Fed may yet win this fight.
Kerry Craig is global market strategist of JP Morgan Asset Management
