Rick Rieder, Chief Investment Officer of Fundamental Fixed Income at BlackRock, and Co-Manager of Fixed Income Global Opportunities (FIGO), comments on yesterday’s Fed Policy Statement.
In her February 24 Humphrey-Hawkins testimony before Congress, Fed Chair Yellen made her view of the path toward the beginning of policy rate normalization abundantly clear. Initially, Dr. Yellen contended, the Federal Open Market Committee’s (FOMC) forward guidance would be adjusted. Further, she argued that any rate policy change was unlikely to occur before June, but at that point, a possible rate move might occur on a meeting-by-meeting basis.
That is, of course, assuming labor markets continue to strengthen and inflation remains stable. With the removal of the “patience” language, and a number of other modifications in yesterday’s FOMC statement, Chair Yellen’s first condition has now been met. And given the robust labor market conditions witnessed in recent months, we expect the Fed to lift policy rates in the next several months with a tilt toward September now rather than June. Regardless of the precise timing, however, the start of policy normalization should begin this year.
Some will argue that recent softness in select US economic data points, the strength of the USD, oil price volatility, and continued uncertainty with global economic growth prospects will combine to delay Fed policy normalization, but we believe such analyses miss much of the point.
While clearly a short delay is possible, and expected given the FOMC statement and Chair Yellen’s press conference, the precise date of lift off is less important than the fact that it will come soon, and the path of policy rate normalization after lift off (now expected to be considerably more gradual, as we have long thought would be the case) is far more important than handicapping an exact date for the event.
As was discussed in the Fed’s statement, and displayed in the Fed’s Summary of Economic Projections, the consensus at the FOMC is for more moderate economic growth in the years ahead, as well as for subdued rates of inflation, which are expected to return to longer-term, near 2%, levels by the end of 2017.
Nevertheless, we think the Fed currently has a window of opportunity to move, with stable markets, payrolls growth at extremely high levels (and momentum improving), and foreign central banks (most notably the European Central Bank and the Bank of Japan) taking the reins of policy accommodation. As a case in point, the US labor markets continue to power ahead, creating two million new jobs in the past seven months, and the last time that 12-month jobs growth was as strong as it is today, the Fed’s policy rate stood at 6% (versus near zero).
We strongly suggest that Fed rate normalization will not only be borne well by the economy, but that it may actually hold a positive impact, while keeping rates excessively accommodative almost certainly holds an increased risk for markets.
Still, some highly respected market observers liken our current situation to the one the Fed faced in 1937, when premature Fed tightening led to an extreme equity market sell-off and a faltering in the economic recovery. We would approach historical analogies of this kind with a high degree of caution, as both historical circumstances and the Fed’s reaction function are not mere echoes of past crises.
The Yellen Fed is likely to be very deliberate and careful in its initial policy moves, remaining sensitive to the incoming data. Moreover, with a zero-rate starting point, a shorter-term goal for Fed Funds near 1% and a medium-term goal of the policy rate near 2%, can hardly be described as tight, but merely no longer at excessive “emergency” levels. Additionally, we must also recall the “stock effect” that stems from the $4.2trn Fed balance sheet will help keep financial conditions accommodative, as will foreign central bank activity.
We must also keep in mind that market conditions are quite different today than they were even a dozen years ago, much less decades ago. In fact, today markets tend to pivot off of long-end rate levels, rather than short-end rates, as was the case prior to the financial crisis. Fed policy is penalizing savers and holders of cash, to instead benefit borrowers, but that has resulted in some questionable capital allocation decision making and financial asset price distortions that could in time risk the Fed’s broader goals through the instability they can produce.
And while many have fretted over the fate of emerging market economies in the face of Fed policy normalization, we think that the EM space is often pained with an overly broad brush. Countries such as Mexico, India, and Indonesia reside in very different (and more favorable) leverage and foreign exchange reserve positions than they have in the past. Without question, some EM economies will struggle, particularly if they see significant capital outflows, but a more normal policy rate level in the US should not imply crises for these countries.
In the end, the FOMC has telegraphed its intentions quite well, in our estimation, and while normalizing policy will certainly cause some tensions along the way, investors would be well served to “look past” near-term volatility and focus on longer-run influences to markets, such as the profound demographic changes working their way through developed market populations, and the rapid pace of development in transformative technologies. In our view, the influence of monetary policy on economic growth and inflation is massively overstated today, and in many respects this degree of “emergency” accommodation has overstayed its welcome.