At its April confab today, the Federal Open Market Committee made no new policy moves and hardly any consequential changes to its plans for monetary policy. Given the uneventful headlines, it is easy to overlook the seismic shifts going on just beneath the surface that will impact policy and markets for the remainder of 2016. The FOMC is resolving deep divisions among its members and is in the midst of altering its reaction function. The following dynamics should not be overlooked:
The incoherent and conflicting signals sent by Fed speakers reflect the two competing factions on the committee. Over the past few weeks, Fed speakers have sent an astounding number of mixed signals and conflicting messages. From the recent banter, it would be easy to conclude that the Fed’s communication strategy is hopelessly muddled and incoherent. The truth is, however, that these mixed messages accurately reflect a deeply divided committee. The FOMC is split into two polarized factions, and each side is airing its view.
For example, at its meeting in March, the FOMC issued a strikingly dovish statement. Within 48 hours, inflation hawks — or so-called inflationistas — like Esther George, Loretta Mester and Jeffrey Lacker were publicly airing contradictory views that differed sharply from the cautious tone of the statement. After no fewer than six FOMC inflationistas voiced their opinions that contrasted with the March statement, Fed chair Janet Yellen reasserted control over messaging. In a speech two weeks after the March FOMC meeting, she forcefully reaffirmed the consensus case for her faction: those who advocate watchful waiting.
So what should investors expect from Fed communication going forward? The airing of differing views has come to be a feature of the Yellen Fed and will almost certainly continue. The inflationistas are likely to remain very vocal dissenters, which may lead to dissenting votes as well.
Which faction on the FOMC will ultimately prevail: Inflationista or watchful waiting? The committee’s prevailing view clearly leans toward the watchful waiting faction, led by Yellen, Fed governor Lael Brainard and New York Fed president William Dudley.
With interest rates near their historic lows, the Fed’s ability to respond to unexpected surprises in inflation and growth is asymmetric — that is, if economic conditions were to strengthen more than expected, the FOMC could easily address this by raising the policy rate. By contrast, if the current economic expansion were to encounter a negative shock or if inflation were to drop suddenly, the FOMC would only be able to provide a modest amount of additional stimulus through policy interest rate changes.
So what does this new reaction function mean for Fed policy and markets in 2016 and beyond? The slower momentum of rising inflation removes the urgency for tightening policy sooner rather than later. Furthermore, the soft inflation and growth data highlight the asymmetric risk policymakers face. Our view at Macro Insight Group on Fed tightening is this: With little impetus to raise interest rates, the FOMC will do so only once this year — in October.
With the Fed likely to be on the sidelines for some time, there is an opportunity for fundamentals to reassert themselves in asset valuations — in the U.S., anyway. Central banks have driven valuations in asset markets for the past several years. As markets come to accept the Fed’s new, dovish reaction function, however, it is very likely that economic and firm-level fundamentals will reassert themselves as drivers of asset valuations — and they will matter more.
Of course, it is not exactly clear that the turn to fundamentals in determining asset prices will sustain current valuations. It is evident that anemic global growth is weighing on the U.S. economy. With few strong drivers of U.S. economic growth in the near term, the economic fundamentals are likely to weigh on asset valuations going forward.
Shehriyar Antia is the founder and chief market strategist at Macro Insight Group, an investment strategy firm based in New York. Prior to founding MIG, he worked on quantitative easing programs and monetary policy as a senior market analyst at the Federal Reserve Bank of New York.
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