Federal Reserve

Four Ifs by Fed, Two Ifs by Me? Why the Reserve Board Will Likely keep Its Interest Rate Powder Relatively Dry in 2016

Since announcing last December that it would increase by .25 percent the range of its base interest rate for overnight lending for nearly a decade, the US Federal Reserve has signaled in multiple ways its intent to continue such increases four times during the course of this year. Initially, this intent was signaled by the release, in conjunction with its last 2015 meeting, of the “central tendency” of the projections of the rate-setting “Open Market Committee” participants (the now famous “dot plots” on a graph). Those plots showed that, disregarding the highest and lowest projections, the middle of the pack of opinion was represented by a path of four rate increases of .25 percent each by the start of 2017. While this would be a slower than usual pace of rate increases by past Fed standards, it would nonetheless bring the base rate to a range of 1.25 – 1.50 percent, essentially a full point higher than where the range stands today.

Ever since then, the US financial markets have more or less indicated their displeasure with this “tendency” in the best way they can to get attention. Bond markets rallied with prices higher and interest rates lower, reflecting a conviction among market participants that economic conditions have veered downward with deflation, rather than moving in the direction of continued modest expansion and 2 percent inflation projected by the Fed at its December meeting. Lately, a number of market participants are going even further and predicting the onset of a US recession (two or more consecutive quarters of negative movement in GDP), which would certainly argue for more, not less, Fed “accommodation” to the market–either in the form of another round of quantitative easing in bond purchases to pump lendable money out to banks, or course-reversing decreases in the base interest rate (for which the Fed has only marginal room at best before “going negative,” as Europe has.

Regardless of whether the bond market is right in suggesting a recessionary case, the equity market, which has been at odds with bond market expectations for most of the last few years, has also been shooting flares at the Fed’s intentions in very dramatic fashion. Indeed, there is simply no historical precedent for the precipitous drop in US equities since the first trading day of the year, when on average an investor lost $16 for every $1000 in the market and has kept on losing money ever since through the first two weeks of the year.

There are, of course, multiple rationales for the equity market correction (a 10 percent drop or more), the second in six months. Indeed, some of the reasons are the same as occurred in August: data showing a serious decline in the Chinese export economy, and a precipitous devaluation of the Chinese currency in the context of continued relative strength of the US dollar, as well as the partially-related continuing decline in the price of oil in view of increased current and anticipated market supply and weakening Chinese and emerging market demand, which also led to a drop in the pace of US manufacturing! In addition, there was a perception in some market quarters that the Federal Reserve might take steps to increase interest rates in September, while the US economy was showing signs of increasingly vulnerability to foreign emerging market damage, caused by the rising value of the US dollar against their currencies (exacerbated by the drop on the Chinese yuan) and the ensuing flight of capital from their economies–which would be made worse by such an increase.

Ironically, the decision of the Fed to hold off an expected September rate increase was roundly criticized in some quarters because the Fed expressly cited global economic conditions potentially threatening the US recovery as one of its reasons for deferring the first increase at that time. These critics said the Fed has no business taking foreign situations into account to the extent that it seemed to be adding a “third mandate” in terms of global financial market stability to its list of responsibilities.

Now, the Fed was never adopting a third mandate to work for foreign countries. Its September focus on negative Chinese and global economic trends was quite obviously because of the potential US-side effects of those negatives on the Fed’s statutory twin mandates–optimal employment and stable prices! Indeed, today’s Fed critics are adopting that very same perspective the Fed was criticized for back in September, urging the Fed to most certainly pay heed to the adverse developments in the Chinese and emerging market economies because they may be leading to a global recession that will be imported along with attendant deflation to the US.

Nonetheless, in the past week, both Vice Chair Stanley Fischer and New York Federal Reserve Bank President William Dudley went out of their way in public remarks to assert that the projected four rate increases this year were still “in the ballpark” and definitely on the table, notwithstanding the offshore negatives. Yet the minutes of the Fed’s Open Market Committee’s December meeting, released January 6, reveal the Fed itself was divided and unsure of the direction of the US economy, citing “significant concern about the still low readings on actual inflation” and “risks present in in the inflation outlook.” These concerns would now seem to be increased by the continuing drop of the current market price of oil to levels below $30 per barrel, not seen since 2003.

Coincidentally, the same Business Section of The New York Times that offered the headlines “Oil Prices Decline More than 5 Percent as Stockpiles Increase,” and “New Fears of a Slowdown in China Spur Selling” (January 7, 2016) also contained the article titled “Minutes Indicate That Fed Still Has Inflation Doubts.” The story noted questions about how much farther Fed officials are willing to raise rates without clear evidence the pace of inflation is also rising. Fortune Magazine had a similar take on the Fed’s divided state of mind.

In the coming days and weeks, there will be multiple data points to be considered before the Fed’s coming January and March meetings (nobody expects a rate increase in January, but the “four more hikes” play call virtually requires one in March) by a Federal Reserve that has promised its interest rates decisions going forward will be “data dependent,” regardless of their dot-plot projections: fourth-quarter 2015 GDP (currently within 1 percent or less of recession levels in most forecasts); January and February employment reports; manufacturing and service business trajectory; consumer spending levels; retail and housing sales; and, of course, producer and consumer price levels. A generally centrist Fed official, St. Louis Reserve Bank President James Bullard, while not directly contradicting the “four more in 2016” rate rise track, did note the potential impact of falling oil prices on the Fed’s 2 percent inflation target. This note may well imply that such incoming data will prove to be more important than the dot-plot projections of four rate increases this year, especially because of the effects of further downturns in China on the drivers of that data, such as the price of oil and the prospects for currency-related, deflationary discounts on products imported to the US.

But there have been very few mentions of another factor that could tip the balance against four or more rate increase this year: 2016 is a presidential election year. The Fed meets only eight times a year, so four increases would average one increase every other meeting. Assuming the incoming data causes a March deferral, that would leave only six for four, right into the teeth of the nominating and final election campaign. George H. W. Bush famously blamed his re-election loss in 1992 on the Fed’s Alan Greenspan, for his resistance to cutting interest rates faster during the recession preceding the vote.

The Fed certainly would want to avoid a mistake in terms of excessive interest rate increases that tip the economy into recession (that’s why its public statements hedge with respect to “data dependence”). But it would also not want to be perceived to tip the election to one candidate or another; let’s just call that “date dependence”–the date of the election! The prediction here is that this year will see two rate increases at most: one in April or later, and the other after the election in December.

For the moment, Chinese GDP data has come in at 6.9 percent for 2015, down .4 percent from the prior year and in line with reduced expectation, stabilized by retail sales growth of 11.1 percent year over year (just short of estimates), while manufacturing contributions continued to tumble as expected.

These numbers reflect an overall 25-year low in GDP, but also suggest a level of stabilization that left markets in Asia marginally positive, with Shanghai up slightly as well. What remains to be seen is whether these numbers will in turn stabilize the US markets enough for the Fed to jump ahead with a .25 percent increase in March. And that would seem to turn on whether the strong employment data averages of 284,000 net new jobs in Q4 2015 will persist, and whether there emerges actual (not just projected) upward inflation data in Q1 2016. The sense here is “no” on both counts–and that might mean the US equity market could even turn upward, as it did eventually after last September’s Fed flinch.

Questions for the Markets

1. Euro and Euro sovereing debt prices go down, the Us market goes down (even with strongly improved US employment, manufacturing and consumer spending). Are hedge funds that are short the US stock market and anxious to get back long at lower levels effectively shorting Italian and Spanish sovereign debt with derivatives in order to drive down the US markets?  (Yes.)

2. Did the stock market get traded down by the big funds on this friday get traded down despite the good employment numbers because those numbers tend to help Obama, whom the  hedgies hate? (yes again.)

3. Are the Euro currency and bond vigilantes driving down sovereign  bond prices this week to force “Markozy”to give in to market pressures at their meeting next week and turn loose the ECB to directly support bond prices? (Not a chance.)

4. Will the ECB lower interest rates next week? (My guess yes, but the market thinks no because of the falling Euro. But  note that Germany must really, secretly like the falling Euro, at least for a while — helps their exports outside Europe.)

5. Is Standard and Poor’s holding off downgrading France because it has become afraid they will be blamed for killing Sarkozy’s re-election and ushering in a Socialist government in France in this April’s election?

6. Will the US Fed announce QE III in the mortgage bond markets sometime shortly after its January meeting? (Y

7. How many governors (and current opponents) has Romney promised  to be on “really  short list” he VP nomination to? (at least six.)

 

 

 

Better Fed Than Dead

Terry Connelly is dean emeritus of the Ageno School of Business at Golden Gate University and is frequently quoted on business, financial, and economic issues by Bay Area local, as well as national, news media.

 

Traders ares speculating that the fed is bound to disappoint the markets on wednesday as there is really nothing much they can do tohelp the economy grwo any more, and nothing much that they can agree on in any event. I think they are wrong, on both counts.

 

As to the second matter first — Ben Bernanke’s background is not in the corporate world, where a Board of Directors, like the Fed’s Open Market Committee at least in structure and mission, is expected to be unanimous or nothing at all. Instead, the Chairman’s background is steeped in academic strcuture. Like any dean of a strong minded faculty (including myself, although I have lived in the other world of business, too), he knows that no faculty is likely to be unanimous about anything, and it does not bother him particularly even he has two or three public dissenters to Fed policy. And he gets great marks from his colleagues for courtesy and openness. Most faculties prefer to debate more than decide, anyway, because down deep they have mutual respect for their diverse opinions, no matter have pointed their disagreements. Ben will do a deal with majority support and not hold out for the “perfection’ of unanimity. You don’t have a specially-extended  two-day meeting and then do nothing; unless you want to contribute to market carnage.

 

And what ‘s to be done? Lengthening the maturity of the Fed’s balance sheet (the so-called “twist’) was sexier  when it was really just a teenage dance move, but it would help hold down longer-term interest rates that are the base for mortgages and consumer loans. Lowering the interest rate it pays banks to keep their excess reserves on deposit with the Fed will also help at the margin to push them to lend, finally. (This step should be staged to prevent a huge washover of deposits into money market funds and risking their valuation.) Both these moves would be welcomed by the financial markets, especially in terms of reducing the current obsession with every choreographed move in the Greek default process, as the “troika” of EU. ECB and IMF negotiators string bailout approval VERY PREDICTABLY BUT ALSO INEVITABLY  to the last minute so as to hold in check the negative public  opinion in Germany about spending more money on the Greeks. (They cannot afford to be scene as anything other than the strictest of lenders, so they drag things out to create that impression while the markets forget that it was just last week that Merkel and Sarkozy said the deal would get done! Traders can be downright stupid at times.)

And, by the way, don’t let this loose talk that we’d all be better off just to let Greece default right now (rather than waiting until 2013 when the lead countries of the European Community get their banks in shape to sustain losses in a managed default) get the better of your memory. That’s what folks said about “letting Lehman fail” before the great mistake (predicted in this blog) that triggered the Great Recession. Moral: don’t listen to the drumbeat on CNBC, ever!

 

 

 

 

Sarbanes-Oxley for Banks? Bye-bye Ben?

Terry Connelly is dean of the Ageno School of Business at Golden Gate University and is frequently quoted on business, financial, and economic issues by Bay Area local, as well as national, news media.

The Obama “Volcker Rule” precluding banks from proprietary trading amounts to a form of the famous Sarbanes-Oxley Act’s requirement that accounting firms exit the business of consulting for their clients (which was the only consulting worth doing). What Volcker probably wants is a return to the good old days of Wall Street partnerships where the trading risks literally went home with the investment bankers every night, but that “back to the future” scenario is unlikely to emerge. More likely Goldman Sachs will “de-bank” itself as soon as it can, even if  it can no longer access the “Fed window” for emergency loans (it already has a “Buffet window”, albeit at a much higher cost).

What is more troublesome is how banks with customer trading business will be able to make a market for their clients and hedge their own institutional risks arising from taking down positions, albeit temporarily, to accommodate clients.  Surely from a public policy point of view we would not want the banks to either stop making markets for their clients, or to increase their own institutional exposure by not hedging the risks to their own balance sheet derived from their client accommodation trades. While technically such hedging is of course intended to protect their own account, it does not seem to be the kind of proprietary “speculation” with Federally-protected money that Obama and Volcker want to eliminate. Yetr it would seem to be in the crosshairs of the Volcker rule

Bearing the SOX experience in mind, Congress and the Administration need to take this proposal through a careful vetting to avoid the unintended consequences which always come from hasty legislation. Right now, the biggest beneficiaries of this proposal look to be not the taxpayers but the independent private equity firms and hedge funds not associated with banks. Even if one took the view that, like the accounting firms that gorged on consulting earnings, the banks may have only themselves to blame for this proposal,  that would not excuse an accidental attack on truly useful and legitimate practices which in fact promote the proper functioning of the financial markets.

In addition,  the new  rules’ proponents  should explain what the proposed ban on banks “advising” hedge funds or private equity funds entails: does this include providing M&A advisory services and opinions; does it include stock research? Such a prohibition would amount to a back-door partial  reinstatement of Glass-Steagall, which  should be debated much more transparently.

Finally, on the subject of banks, is the biggest of them all (the Federal Reserve) about to be needing a new CEO? There is a sense that, as in the case of the omnibus health care reform bill, the votes might not be there in the Senate for Chairman Bernanke’s reappointment: will Ben be the next victim of Scott Brown? Or Geithner? Stay tuned: life is unfair, as the former Massachusetts Senator JFK once remarked. (But he would have never said his daughter was “available”  at a victory rally!)