Reasons the Fed won’t raise rates
I had been intending to write this post as a counterpoint to what I wrote yesterday about curve inversion. The Chief bullet point was going to be about the Fed’s not wanting to create curve inversion. But with the Swiss National Bank move, that changes to the Fed’s not wanting to destabilize global monetary policy. Thoughts below
My last post was on my initial reaction to the Swiss National Bank’s abandoning its floor on the Swiss Franc at 1.20 Francs to the Euro. The Franc is trading near par to the Euro as I write this. So that’s a big move, the largest in my own memory for developed markets. I am simply blown away at how violent the move up in the Swiss Franc was. So I think this changes things for the Fed somewhat.
Before I go into why this changes the Fed’s calculus, let me say that James Saft at Reuters told me he doesn’t believe the Swiss were reacting to Fed policy, more to European policy i.e. Euro weakness and the ECB/Greece turmoil. That sounds right. But, of course, the SNB can better have an impact on US policy by just focusing on policy divergence i.e. the divergence between the ECB and the Fed.
Having listened to SNB head Jordan’s press conference, a number of points struck me as relevant to what’s happening in the currency markets that could affect US monetary policy. Here are a few bullets:
- Jordan believes the tax on deposits at the central bank works in concert with the drop in oil prices against deflation. I think this is completely false because it is a tax and taxes reduce demand and therefore add more deflationary pressure. In the short term, even though a drop in oil prices is like a tax cut, it will negatively affect headline CPI. But irrespective, Jordan believes he is working against deflation here. I believe the thinking at the ECB is similar. And so I expect something similar from the ECB on 22 Jan. And this will be perceived as increased policy divergence. The SNB is just front-running the ECB.
- The SNB thinks that 1.20 floor’s day was over because of divergence between the ECB and the Fed. And in the press conference following the SNB policy decision, Jordan repeatedly talked about his hand being forced by monetary policy divergence. Now, the Franc was pegged to the euro at 1.20. So one could interpret this as a sign of divergence driven by ECB policy. My sense, however, is that the decision is also driven by Fed tightening because every other central bank has backed away from tightening including the Bank of Canada, the Bank of England and the Reserve Bank of Australia.
- The SNB has move to making currency intervention decisions based on the full palette of currency moves rather than focusing just on the ECB. This is a tacit admission that the ECB’s policy is too dovish for the Swiss to be able to hold the line. The move to the ‘basket’ approach (though Jordan rejected that term ‘basket’ explicitly in the press conference) supports James Saft’s view that the SNB move is more of a reaction to the ECB than to the Fed. But the SNB can only get US policy to become more dovish. The SNB cannot get ECB policy to become more hawkish.
I think this puts huge pressure on the Fed to reverse course and not tighten policy further by raising rates. The move in the Swiss Franc should be seen as casualty of a strong dollar, just as oil and commodities have been in part. Janet Yellen has said that she cares how Fed policy affects other economies and global economic conditions. A 28% move in a major global currency in one day that is blamed on policy divergence has to figure into Fed calculus then. Consider the Swiss Franc move a big phase shift in the currency wars then. It gives the 22 Jan ECB policy move more importance. And makes the 28 Jan Fed meeting more important. If we do not see a more dovish Fed on 28 Jan, markets will believe policy divergence remains and that will put upward pressure on the US dollar. I don’t think Yellen wants this and the Fed may change course as a result.
Before the SNB announcement, I was going to focus more on the yield curve though. In the wake of the SNB move, 12-month Treasuries are now yielding 0.15%. Irrespective of whether this is a safe haven bid, that is a figure which is well under 0.25%. Where the Fed would have to move if it raised rates given it now has a band between 0% and 0.25%. The Fed could move to increase the floor of it’s band to 0.10% as a token gesture and keep a band at 0.10% to 0.25%. But I think the fact that rates out to one year are below 0.25% is significant. Moreover, the 2-year Treasury is trading at 0.46%, under 0.50%, meaning hiking twice would put the policy rate above the present two-year rate.
My understanding in following the Fed is that in the past the Fed tightens to cool the economy when the yield curve is relatively steep. And the yield curve flattens or eventually inverts. The Fed does not tighten to create the inversion. I will have to go back and check the data. But I believe the inversion occurs later and that the Fed is hiking to cool credit conditions and has generally not created inversion. In short, it would be a huge departure from form if the Fed were to raise interest rates in such a way that its policy move created a yield curve inversion straight away. For that reason alone, I believe the flatness of the yield curve is restricting the Fed and may give the Fed room to avoid hiking.
There are other reasons but I am going to stop here. I do want to remark that these are interesting times. The SNB policy decision and the violent reaction demonstrate that the global economy is not well and that almost 8 years after crisis began with the Household International writedown of February 2007, monetary policy is in an abnormal state. We have never been here before and we simply do not know how policy choices will change the playing field. What we should know, however, is that this abnormal state of affairs means that the fingers of instability are everywhere and tail risk is heightened. The Swiss Franc move is demonstration of this.