Fed flip-flops are a reflection of global uncertainty

 
Markets engaged in an unhealthy codependency with central bank policy
 
 
 
All it took was last Tuesday’s reassuring speech from Federal Reserve chair Janet Yellen for vocal market participants to change a narrative that had depicted the central bank as “inconsistent” and “confusing”. Yet the underlying issues are real and will not go away any time soon. Rather than point to Fed mishaps, they speak to the context in which it operates and the markets’ unhealthy codependency.
 
In the past three months, Fed policy signals have visibly fluctuated several times. Having initiated a tightening cycle by raising US interest rates in December for the first time in almost 10 years, the markets’ interpretation of the “blue dots” that Fed officials (inadvisably in my view) disseminate to express their individual paths for future policy pointed to four additional hikes in 2016, followed by another four in 2017.

With this representing a tightening well in excess of what market participants were expecting, pronounced market volatility ensued, accompanied by an unsettling sell-off in risk assets.

Concurrently, concerns intensified about economic weakness abroad, even to the extent of making some people worry about a US recession.

In response, the Fed adopted a noticeably more dovish intra-meeting tone. Calming remarks from several officials culminated in a policy meeting that revised downwards the blue dots so as to signal the possibility of just two hikes this year.

Comforted by rapidly recovering financial asset prices (including a 10 per cent surge in US stock indices and more abroad) and relative global economic stability, Fed signals changed once again with some officials even suggesting that a hike could be warranted as early as April. This immediately paused the global equity rally, leading vocal market participants to accuse the Fed of inconsistent and confusing communication. Some went further and openly doubted the credibility and competency of the institution.

Such criticisms were put to rest, at least for now, by last Tuesday’s speech by Fed chair Yellen to the Economic Club of New York. In noticeably dovish remarks that were music to ears of market bulls, Ms Yellen emphasised the external headwinds facing the US economy, the asymmetrical nature of the policy risks, and persistent structural puzzles. With that, she stressed that the Fed’s policy response would be cautiously gradual, erring on the side of accommodation. Equities took off, ending a winning “V-shaped” quarter not just very near year-highs but also near some all-time record peaks.
 
As much as markets dislike such flip-flops, they should recognise that rather than reflect Fed slippages they are due to the unusual world in which we live.

Three specific realities underpin what is a responsive rather than a serially inconsistent policy stance; and neither the Fed nor many others have been able as yet to fully comprehend: the failure of consistently robust wage growth to follow what has been a remarkable period of new job creation; the balance between structural and cyclical factors, holding back labour participation, productivity growth and inflation; and, for an institution that has traditionally been very US-oriented, the need to balance unfavourable international economic influences with a better positioned domestic economy.

These are issues that are not going to be resolved any time soon — and especially in a policy world that is grossly over-reliant on central banks and whose underlying growth dynamics have deteriorated in recent weeks.
 
As such, market participants have a choice: either break away from a codependency that has served them well but, almost inevitably, exposes them to volatility in the short term and the possibility of major losses over the longer-term if economic and corporate fundamentals fail to improve significantly; or continue to ride the rollercoaster powered by signals from a data-dependent Fed that operates in an unusually fluid globally economy.

What should happen — namely a return to fundamental-based investing — is not what is likely to happen any time soon. After all, few investors have the conviction needed to break away from a herd that has done well so far and collectively believes it is still able to influence Fed policy in a self-serving manner. As such, the unhealthy codependency will persist for a while, and the loud complaints will recur the moment the Fed again changes signals . . . as inevitably it will do.


Mohamed El-Erian is chief economic adviser to Allianz, and author of the book “The Only Game in Town”

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