Uh oh! It now appears clear that the Federal Reserve (Fed) is going to raise interest rates in December.
On a cyclical basis, if the Fed is so inclined – and I believe it is – the evidence in support of monetary policy tightening (or normalization, if you prefer that euphemism) keeps piling on.
The U.S. Labor Dept.’s October 2015 employment report, which came out on Friday, Nov. 6, was much stronger than economists expected on virtually every front:
- The headline number showed that payrolls increased by 271,000, not only higher than expected but significantly higher than the breakeven number.
- The unemployment rate edged down 0.1% to 5%.
- Even the U-6 number, which measures underemployment, moved lower.
- Wages inched up, coming in 0.4% higher month-over-month in October.
In other words, if the Fed is data dependent, as it says it is, the data that matter most came in much better than expected.
Probability of Rate Increase Rising
As a result, the probability of the Fed tightening after the December 15-16 meeting of policymakers has gone up, in our view. The market is assigning a 70% probability of tightening; I believe it is higher. It seems to me that even if the data over the next month-and-a-half normalizes from the strong October levels, the Fed will still tighten.
For the Fed not to tighten, the threshold for weakness in data and/or market volatility is quite high at this point. For example, November job gains of 150,000 will still lead to tightening. It would take a sub-100,000 month, at a minimum, to change the Fed’s outlook.
I completely get the Fed’s cyclical logic: The U.S. economy is doing quite well and the pace of domestic economic growth does not warrant policy support at the current level.
However, if Fed chair Janet Yellen and her policymaking colleagues want to be solely focused on cyclical and U.S.-centric views, they should not have waited this long, they should have tightened a while ago. The secular outlook is still quite negative, especially on a global basis. The implications for the data flow and consequent Fed tightening are, in my mind, far less sanguine than what the market memes imply.
Higher Rates, Higher Volatility
I believe the markets will construe Fed tightening in December, even if it is a measly 25 basis points, as a regime change and, as a result, the baseline for overall volatility is likely to move higher. That will not be good for equities, credit or any other risky asset in the near term. The channel for all of this is going to be the U.S. dollar, which will strengthen and, in turn, slow growth throughout the world. It is still a deleveraging world, and a policy tightening and regime change in the world’s largest economy cannot be a positive development, in my humble opinion.
To be sure, other central banks are still easing and may ease even further, and that will help support global growth. Nevertheless, what the Fed does matters a lot more from a signaling standpoint than it would like to admit. Similarly, the implication of the Fed’s actions for the world’s reserve currency, especially in a deleveraging world, cannot be overemphasized.
So, it seems the Fed’s going to go higher in December and I am worried. I hope my fears prove to be unfounded.
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