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Investors may be taken for a ride by today’s Minutes of the Federal Open Market Committee (FOMC), which
expand on the FOMC’s March 13, 2012 statement; in the interim, we believe the Federal Reserve
(Fed) Chairman Bernanke has gone out of his way to assure the markets that
monetary policy will remain “highly accommodative,” at least
through late 2014.
The Fed does indeed have a credibility problem:
having assured investors that rates will remain low for an extended period,
it may only take one or two FOMC members to turn more optimistic about the
economic outlook to cause the markets to more aggressively price-in tighter
monetary policy. Conversely, Bernanke has made it clear that he is most
concerned about a recovery in the housing market and that low interest rates
– throughout the yield curve – are desirable. Operation Twist is
specifically aimed to achieve that, lowering long-term rates and flattening
the yield curve. However, should investors become increasingly optimistic
about economic improvement, odds increase that investors sell bonds, putting
upward pressure on long-term rates.
To understand the Fed’s “communication
strategy”, one needs to be aware of who is calling the shots. We are
not just talking about Fed Chairman Bernanke, but also the composition of
voting FOMC members. Without a doubt, the “hawks” (hawks are FOMC
members considered to favor tighter monetary policy compared to
“doves”) on the FOMC are getting more vocal. At the same time,
the only voting “hawk” on the FOMC this year is Richmond Fed
President Jeff Lacker:
The scale may tilt a tad towards the
centrist/hawkish side should Congress fill the two vacant seats with the
candidates under consideration. Still, when all is said and done, it is the
voting members who ultimately determine imminent monetary policy decisions,
rather than the noise created by non-voting members. And those actions
remain, in our interpretation, decisively on the dovish side:
- “almost all members again agreed to…maintain a
highly accommodative stance…”
- “a number
of members perceived a non-negligible risk that improvements in
employment could diminish as the year progressed”
Obviously, should economic data continue to surprise
to the upside, the Fed will have an ever-more difficult time defending its
dovish position. The credibility of the Fed will be seriously tested as the
Fed has committed to keeping rates low until late 2014. However, should we
enter a weak patch, we believe the odds are rather high that the FOMC will
“take out insurance” against another slowdown. In a world where
everyone hopes for the best, but plans for the worst, central banks around
the world – including the Fed - may keep the world awash in money.
After all, a world laden with debt may need
inflation if deflation is to be avoided. Bernanke has argued many times that
tightening monetary policy too early was one of the biggest mistakes the Fed
made during the Great Depression. We don’t think Bernanke will repeat
this. Indeed, we consider he will err firmly on the side of inflation. As
such, when the dust settles, look at actions, not words. We see doves, not
hawks, managing the monetary aviary.
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their impact on currencies.
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