The Fed’s Mandate, US Policy and the Rest of the World

The Fed’s objectives, as set by Congress, are to maintain stable prices and to maximize employment.  This “dual mandate” is accompanied by a rarely cited third objective, to maintain moderate long term interest rates.  Those should be a natural outcome of maintaining stable prices, defined as keeping the Personal Consumption Expenditure price index near 2%.   The Fed has no mandate covering the rest of the world despite the inevitable grumblings by foreign worthies when it changes policy.

If you are trying to decide whether the Fed will move, think about its statutory responsibilities.  Monitor inflation, growth and the labor market.  Unless we are in the midst of a financial crisis, the Fed is going to base its decisions on its outlook for US economic indicators.    The US is not in a financial crisis.  China may be.

This idea that the Fed is the world’s central bank surfaces regularly in the face of turbulent markets.  While it might feel like asset Armageddon and some market movements may be in anticipation of the Fed tightening policy, the Fed has nothing in its mandate to do with anything outside the US. It is responsible for US domestic outcomes, that is all.*

The market believes that the Fed holds fire in September. I agree. This stance can be justified by current US indicators. A month ago the market projected that the Fed would raise rates in September with about 54% probability.  That is down to 24%. The timing for the first hike has been moved out to December.

FFU5-090815

Probability of a rate hike. Source: CME

Inflation is low.

US inflation

That is true even excluding volatile food and energy prices that are unaffected by Fed policy.

US core inflation

US growth is moderate at best.  It has breached 3% just once post crisis.  In previous recoveries, the US would typically see multiple quarters of 4-5% growth.  The chart below shows a clear deceleration in US economic growth in this recovery versus those of the last 25 years.

US GDP

We are living through the aftermath of a credit crisis. Credit crises cause a subsequent deceleration of growth as the lingering debt burden is worked off.  This may be the most important reason that the Fed does not need to rush normalization of rates.  It will also lead, in my opinion, to a lower ceiling for rates across the maturity spectrum during this particular tightening cycle.

While the labor market is recovering, the recovery has been gradual.  The unemployment rate is down to 5.1%, a level that some at the Fed believe will eventually trigger inflation. The broader measure of unemployment and underemployment, known as U6, does not look nearly as robust.

US U1 and U6

Unemployment rate is blue. U6, total unemployed, underemployed and marginally attached is orange.

However, the difference between the the 2 measures, seen below, has come down to slightly below the level it was at when U6 debuted in January 1994.  And January 1994 was the month before the Fed began raising rates in the wake of the last banking crisis in the US. History may not repeat itself, but this does show that we are approaching normalcy even for the extended meaasure of unemployment.

US U6-U1

Inflation expectations have recently nose dived. The expected 10 year inflation rate derived from US governments treasury inflation protected securites (TIPS) is as low as it has been during the recovery.  The 5 year inflation rate expected 5 years from now, also derived from TIPS has come down materially too. These changes in expectations are signals that US inflation will not be taking off any time soon. They have unquestionably been affected by the implications of recent market developments; it is these effects on potential US inflation that are causing the delay in interest rate rises. It is not, per se, the turmoil in international markets.

US Infl Expec

Goods price inflation is likely to stay low or drop as China and other emerging markets countries attempt to maintain employment at all costs. The drop in EM exchange rates will reinforce the coming goods price disinflation.

I believe that much of the market turbulence has to do with the downshift in Chinese growth expectations.  China is going to have to rebalance its economy towards consumption and it will have to deal with the debt it built up in its attempt to maintain growth in the aftermath of the global financial crisis. That burden will weigh on its growth for years to come.

China is going to have to decide whether it wants to remain coupled to US monetary policy through its quasi fixed exchange rate.  It probably does not make sense for the Chinese to do so as the US embarks upon a tightening cycle, but that is another story.

*The US Treasury is responsible for the value of the dollar, not the Federal Reserve.

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