{"id":45694,"date":"2015-10-19T01:04:51","date_gmt":"2015-10-18T23:04:51","guid":{"rendered":"http:\/\/beta.next-finance.net\/opinion\/fed-the-art-of-evasion\/"},"modified":"2019-12-31T00:09:16","modified_gmt":"2019-12-30T23:09:16","slug":"fed-the-art-of-evasion","status":"publish","type":"post","link":"http:\/\/beta.next-finance.net\/en\/opinion\/fed-the-art-of-evasion\/","title":{"rendered":"Fed: The Art of Evasion"},"content":{"rendered":"

The US Federal Reserve maintained a status quo on its interest rates at its September
\nmeeting, thereby extending a period of zero interest rates that has lasted for virtually
\nseven years already (Graph 1). This decision, which ought to have reassured investors,
\nwas on the contrary greeted with further significant equity market falls. Investors were
\nfrightened by the Fed\u2019s press release explaining its decision to the markets. The Fed there
\nreferred to “global economic developments” likely to weigh on US growth and inflation. The hint
\nat the Chinese equity market crash and the micro-devaluation of the yuan is clear. This
\nemphasis on emerging risks as pretext to keep a status quo convinced the markets that US
\ngrowth was, according to the Fed\u2019s best assessment, more vulnerable to external shocks than
\nexpected.
\n\"graph1-federal_reserve_key_interest_rate.jpg\"<\/p>\n

Janet Yellen, the Fed Chair, made an effort to qualify this message the following week, by
\nunderlining that at this stage the emerging-country crisis is not threatening US growth, but only
\ninflation via the low level of imported goods prices (commodities, industrial goods imported
\nfrom emerging countries with weakened currencies). As a result, despite the solidity of real
\ngrowth, the risk of imported disinflation justifies taking out insurance on the stability of longterm
\ninflation expectations. To do so, inflation prospects should be stimulated in the medium
\nterm by temporarily pushing the economy into overheating. According to this approach, the
\nimpact from imported disinflation on headline inflation is offset by high inflation in the prices of
\ngoods produced locally.<\/p>\n

Janet Yellen nevertheless stressed that she and majority of her FOMC colleagues expected a
\nrate hike this year. The Fed has thereby tied its own hands, as only downright disappointing
\ninflation figures could enable it to once again delay the rate hike without sparking panic in the
\nmarkets.<\/p>\n

But that is not the most dangerous risk of this \u201ctemporary overheating strategy\u201d. In our opinion,
\nthe danger is that it assumes that the central bank is able to fine-tune the economy, which is to
\na large extent unrealistic. Admittedly, the unemployment rate can be driven lower than its
\nequilibrium rate without fear of a wage surge, because of the still significant presence of
\ninvoluntary part-time workers in the labor force (Graphs 2 and 3).
\n\"graph2-united_states-unemployment_rate.jpg\"
\n\"graph3-united_states-involuntary_part-time.jpg\"<\/p>\n

This population is a labor reserve that companies can draw on to increase the number of hours
\nworked without increasing the hourly wage. But as soon as this “reserve army” is exhausted,
\nemployers must attract to the labor market persons whose reservation wage (the wage at which
\nthey accept to take a job) until now has been higher than those offered. As a result, the ongoing
\nfall in unemployment will generate noteworthy wage increases (Graph 4). Given the structural
\nweakness of productivity gains, companies will then have the choice between passing this
\nincrease in labor costs on to the final consumer in the form of final price inflation or dampening
\nit by reducing their margins.<\/p>\n

\"graph4-united_states-average_hourly_wage_private_sector.jpg\"
\nIn the first case (increase in final prices), the Fed will, accordingly, be faced with a rapid rise in
\ndomestic goods inflation. While the Fed\u2019s goal is to let this inflation component rise above its
\n2% target to offset imported disinflation, this suggests that the overheating then will be well
\nentrenched in the labor market. If it does not want inflation expectations to soar under the
\neffect of a wage-price spiral, the Fed would therefore have to make a U-turn in its policy and
\ncarry out a rapid rate hike. If it balks at this, it is the bond market that will cool down the
\nmachinery thorough a surge in long-term interest rates. Such an interest rate shock, whether
\ninitiated by the Fed or the bond market, might trigger an equity market crash. The markets
\ncould even expect this reaction, which could create detrimental volatility for the intermediate
\nmaturities of the yield curve.<\/p>\n

In the second case, it is companies’ margins that would be reduced, leading to declining
\nprofitability and investment as well as a risk to market valuations. We believe the latter financial
\naspect of the reasoning is particularly sensitive in the current situation. As we have often seen,
\nthe valuation levels of a number of asset classes show an end-of-cycle shape – at a time when
\nthe monetary normalization cycle has not even started. Continued monetary laxity by the Fed
\nwould encourage investors to inflate these valuations even more, and they would therefore be
\nall the more vulnerable to the future interest rate shock that Yellen\u2019s strategy promises in her
\nstatement.<\/p>\n

Does the Fed really believe in this risky monetary U-turn strategy? Or is it quite simply seeking
\nto hide its own doubts behind vague statements? There are doubts about its ability to protect
\nthe US against the adverse winds blowing from Asia. There are doubts about its ability to obtain
\neven a semblance of monetary normalization in a growth cycle that is already fading in some
\nrespects (stock, private debt, market valuations). Unlike in 2004, when the Fed\u2019s previous policy
\ntightening cycle started, a monetary cycle deployed in today\u2019s situation would not be dampened,
\nbut, on the contrary, exacerbated by the effects of the financial cycle (tightening of lending
\nconditions, contraction in stock multiples) and the currency cycle (steep appreciation of the
\ndollar in a context of a currency war). The Fed is completely aware of this. It is getting trapped
\nin its own contradictions, and markets in search of direction would be wrong to expect more
\ntransparency in its words, except the promise of persistently high volatility.