If you’ll bear with me for mixing metaphors, the title of this blog describes to a tee the situation the U.S. Federal Reserve (Fed) and Fed Chair Janet Yellen find themselves in with other central banks, including Bank of Japan (BOJ) Governor Haruhiko Kuroda.
Let us start with January’s Federal Open Market Committee (FOMC) meeting. If one were optimistic, one could describe the FOMC communique as dovish, and there is enough in the note to support that line of thinking. The FOMC mentions slowing growth, although more in inventory terms rather than spending and investment. It also mentions global developments but passes on balance-of-risk statements.
However, if one were a little less optimistic, the repeated comments on the strength of the U.S. labor market might make one nervous. What the FOMC was in essence saying is that yes, the U.S. economy was slowing in the fourth quarter of 2015, and yes, global and financial market developments have them worried, but there is enough strength in the U.S. labor market for them not to back off from their tightening stance.
The bottom line, from my perspective, is that while the Fed may seem to be sounding a tad dovish, unless the labor market starts softening, Fed policymakers are far from done with tightening.
As a result, while there are reasons to be hopeful for risky asset prices, it is far from certain that the Fed will stop tightening now and a reversal of the markets’ thinking on what the Fed will do – which at the moment is nothing for the foreseeable future—is still a substantial downside risk for sentiment.
In a perfect world, where the Fed is the Supremo, that would be the end of the conversation because the Fed is free to do whatever it believes is called for based on the state of the U.S. economy.
However, the situation in the current global environment is a bit different. While the Fed has a lot of latitude, what other large central banks do is equally important. If the policy divergence between the European Central Bank (ECB) and BOJ on one side and the Fed on the other becomes too acute, the dollar will appreciate enough to sink the U.S. economy.
Turning the Tables on the Fed
And that is precisely where Yellen and the Fed find themselves today. Just as the Fed forced every other central bank in the world to get into an easing mode after the financial crisis, the other central banks are now, in effect, turning the tables on the Fed.
First, ECB president Mario Draghi indicated last week that the ECB will be easing further. Then, yesterday, Kuroda and the BOJ unexpectedly took Japanese interest rates into negative territory. As a result, the pressures on Yellen and Fed policymakers will be rising via the dollar to back off their plans to tighten further. That is precisely why the bond markets are rallying and risky assets will, too.
While I am thrilled that U.S. economic growth, the ECB and the BOJ are nudging the Fed to back off, which in turn will be good for stocks and credit, I still am not completely convinced Fed policymakers are fully off the tightening path. If U.S. employment numbers remain strong, GDP growth picks up again in the first quarter of 2016, and financial markets stabilize, they may still tighten in March or June. However, if the employment numbers remain strong but the economy remains in its current funk and the dollar starts climbing, they will have to get off the tightening path more decisively. We shall see.
Nevertheless, while Draghi and Kuroda may be giving Yellen and Company nightmares by forcing their hand, for the sake of the U.S. economy and global financial markets, I for one am thankful because the Fed tightening was a policy mistake from the get go.
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