The Big Tickle

All currencies rallied to the upside against the USD last week except for the euro after the Federal Reserve switched gears. The best performs were the commodity cousins, the aussie and kiwi, in the wake of the Fed’s indecision on an interest rate hike. The euro unwound its post-Fed rally the following day after European Central Bank policy makers noted risks to the global economy. Benoit Coeure, an ECB Executive Board member, said the Fed’s decision vindicates the ECB’s assessment of the uncertainties surrounding the global growth outlook while his colleague on the ECB board, Peter Praet, said in an interview with the NZZ newspaper that the ECB should be ready to act if economic shocks turn out to be long-lasting.

The big tickle for the week was the Fed’s policy shift. Most were probably not surprised that the Fed left rates unchanged at their FOMC meeting last week. That makes it 55 straight meetings without a change in interest rates. The surprise came in the Fed’s reasoning for its inaction – its concerns that developments in the global economy and markets could “restrain US economic activity somewhat”. This change emphasizes that global growth concerns are a real concern, which may cause a risk off environment to develop.

We guess we can call this move a “dovish hold”.

The Fed also released its dot plot plan after the meeting. The plot shows the projections of the 16 members of the Federal Open Market Committee (the rate-setting body within the Fed). Each dot represents a member’s view on where the fed funds rate should be at the end of the various calendar years shown. The latest plot reveals the number of policy makers who do not expect lift-off to happen in 2015 has risen from two to four. Thus, 13 of 17 Fed officials still expect a rate hike this year, which is down from 15 in the June plot. This is surprising considering the new wrinkle towards global growth uncertainty – if the Fed is now “officially” worried about the recent global growth uncertainty is it logical that two months of global data will be enough to alleviate that uncertainty so that they can raise interest rates at their December meeting?

There was yet another shocker in the dot plot. For the first time ever, one Fed policy maker is forecasting negative rates for this year and next (highlighted in red on the dot plot). During the post meeting press conference, Chair Yellen was asked about negative rates and she said that negative rates were not "something we seriously considered" at the current juncture. However, she didn't rule it out – “I don’t expect that we’re going to be in a path of providing additional accommodation. But if the outlook were to change in a way that most of my colleagues and I do not expect, and we found ourselves with a weak economy that needed additional stimulus, we would look at all of our available tools. And that would be something that we would evaluate in that kind of context.”

The implications from all of this are that other foreign central bankers may be forced into further action. With the Fed on hold, dovish central banks may want to ensure that the Fed’s inaction doesn't jeopardize their own domestic inflation targets – thereby setting off another round of monetary easing in the ongoing currency wars.

Why the Fed HAS to Consider the Global Economy

From CNBC found here.

Operating within an economic system where the foreign trade sector represents nearly one-third of demand and output, the Fed must carefully consider price and activity effects coming from the rest of the world. This year, for example, an estimated foreign trade deficit of more than $500 billion is expected to reduce America's economic growth by an entire percentage point. That is because the strong domestic demand – consisting of private consumption, residential investments, business capital outlays and public spending - is stimulating the purchases of foreign goods and services, while the weak economies in the rest of the world, and a strong dollar, are holding back American export sales.

External price effects on American inflation developments are equally strong and straightforward. Driven by a 13.3 percent decline in fuel costs, import prices in the year to August fell 11.4 percent. The non-fuel prices also declined 3 percent, marking their largest drop since October 2009. As a result of that, the headline index of consumer prices (CPI) rose only 0.2 percent in the twelve months to August. But, over the same period, price gains in sectors sheltered from international competition – approximated by the core CPI - edged up 1.8 percent, maintaining the rate of increase observed since the middle of last year.

That enormous difference between the headline and the core rates of inflation shows the strength of externally-induced effects on American costs and prices. And the U.S. inflation story does not end there. What was discussed so far are just the first-round external effects on the domestic price formation process. The second-round effects are arguably even stronger and more pervasive, because an open trading system and declining import prices exercise a vigorous restraint on the pricing power in a broad range of American industries. All this shows how America's foreign trade transactions directly impact the Fed's ability to fulfil its mandate of full employment and price stability.

Employment, in particular, is a difficult part of the mandate. Monetarists have often objected to that. They argue that the monetary policy can only provide an environment of price stability in which demand, output and employment creation can take place. But the mandate is still there, and employment is always a politically-charged issue. Consider, for example, the fact that the current labor market numbers are not as good as implied by the reported 5.1 percent unemployment rate.
Adding 6.5 million involuntary part-time workers (people working part-time because they cannot get a full-time job) and 1.8 million people who are marginally attached to the labor force (mainly people who quit looking for a job because they could not find one), gives an actual unemployment rate that is more than double the official 5.1 percent rate. That also means that the actual number of unemployed is 16.3 million, rather than the reported 8 million. The high numbers of America's long-term unemployed (people out of work for 27 months and over) are reflecting current labor market difficulties as well. These numbers have been increasing since last June to reach 2.2 million at the end of August, accounting for nearly one-third of the reported unemployment.

A similar note about America's soft labor markets is sounded by average hourly earnings; they were roughly unchanged over the three months to August. Now, let's bring back into discussion that 1 percentage point that our foreign trade deficit will knock off the growth of our domestic demand. Even the convinced free traders – of which I am one – have to admit that the immediate effect of that will be job losses in our import-competing industries. The long-term dynamic effects of free trade may well be positive for the world economy as a whole, but that is of little consolation to retrenched workers and bankrupt companies.

The Fed's critics, and American bankers threatening to begin laying people off if the Fed does not promptly oblige with higher interest rates, should understand that there is nothing the U.S. monetary authorities can do about Asians' unrelenting quest for export-led growth, and the European chaos of mean fiscal austerity policies and biblical refugee crises. There is also nothing the Fed can do about structural problems in U.S. labor markets. Only broad and active structural policies – e.g., better and more affordable education, labor force retraining and relocation – could make more people employable in an economy which, thanks to the Fed, is already pushing well above its physical limits to growth.

Foreign trade and labor market policies are the responsibilities of the federal government.
It is not up to the Fed to negotiate better market access to American companies in foreign countries, or to make sure through various G forums (G7, G20, etc.) and multilateral organizations, such as the IMF and the OECD, that economic policies are properly coordinated in order to ensure a fair and a more balanced international trade. And neither is it the Fed's fault that East Asia and the euro area are currently running trade surpluses of $700 billion and $320 billion, respectively, and acting as a huge drag on world economy – extracting that 1 percentage-point gift from the growth of the U.S. domestic demand.

The Fed just has to compose with all that, and to calibrate its policy in order to minimize the negative
effects on U.S. growth and employment of this extremely unbalanced situation in global trade flows. The sad part is that none of these vitally important issues for American economy and security are even mentioned, let alone debated, in the presidential primaries of either party – except for some rather folkloric utterances by Donald Trump, who keeps screaming "they are robbing us blind," and who would treat the Chinese president to a Big Mac instead of a glittering state dinner at the White House.

Somebody has to mind the store. It is easy to criticize the Fed for everything, especially if the Dow does not keep soaring. But the Fed's critics have to understand that economic growth, employment creation and a sound investment environment are a result of an entire policy mix - monetary, fiscal and structural (or regulatory) policies – that is supposed to guide an open economy toward an optimal utilization of its (physical) capital and labor resources.

Having missed the September deadline for the Fed's interest rate increase, the wise-guys are now taking what they call "a December liftoff" as an obvious certainty. Investors, as opposed to traders, should pay no attention to that. People confidently predicting a September rate hike have shown that they can't even read an open book that is called the Fed. The Fed will exercise its mandate as a function of events whose outcome is unknowable ex-ante. The Fed is watching these events like the rest of us. When the data begin signaling the desirability of a policy change, the Fed will adjust its instruments in a manner that will carefully prepare its next move.

So far, the Fed sees nothing that would warrant that kind of action.