In policy matters, just as in life itself, it's all about communication ..... and the Fed is failing badly.

Thursday 15th October 2015

In policy matters, just as in life itself, it's all about communication ..... and the Fed is failing badly.

Ref : " Analyst : There's a Growing Divide at the Fed, and it's Time to Brace for Higher Volatility" , Bloomberg Markets

You've heard of the Phillips Curve, right ? It's a tool that maps out the historically inverse relationship between unemployment and inflation and essentially says that as the level of unemployment falls, inflationary pressures rise. It's long been considered too simplistic by many and just now it looks as though that relationship has seriously broken down. With headline unemployment at  5.1%, the US is very close to full "effective" employment, but that hasn't filtered into upward wage pressures very convincingly and certainly hasn't induced any inflation.

It's not difficult to see why that might be the case. For one thing, the world and the way it does business has changed out of all recognition in recent years  .....  the internet and global outsourcing have radically altered previously-held perceptions about labour costs and therefore prices. Most obviously at this point in time, the rout in global commodity prices (particularly oil) has had a huge and direct disinflationary impact. Throw in the strength of the US dollar and ..... well, it's a no-brainer.

Simplistic and outdated it may be, but Phillips Curve thinking seems to have been at the heart of Fed expectations and policy. There are plenty of good reasons why the Fed should WANT to put up rates but it has been forced to stay its hand by inflation numbers that remain stubbornly close to zero and by the fear of what a rate rise might do to emerging markets and asset prices.

Perhaps they're just confused. If not, they're giving a pretty good impression of it and the mixed messages emanating from Fed officials has in large part created the uncertainty and volatility that markets so hate. This week two members of the Fed board of governors, Lael Brainard and Daniel Tarullo, have questioned the modern-day validity of the Phillips Curve (i.e. the relationship between employment levels and inflation) and with global risks in mind have urged a further delay to any rate hike. This would seem to go against what Fed Chairwoman Yellen and some of her lieutenants have been saying even recently. Vice Chairman Fischer and New York Fed boss William Dudley are speaking later today, and will no doubt re-assert their hawkish credentials in arguing for a rate rise by year-end.

The point is that these contradictory signals, and the confusion and volatility they engender, is the biggest policy issue facing Washington right now ..... bigger even than the fact that the US Treasury will run out of cash on Nov 10th if an agreement to raise the debt ceiling isn't passed by the time a $13bn Social Security payment becomes due. That's bound to be a bloody affair, and it says it all that many consider the Fed issue to be the more damaging. To think that not so very long ago we compared Bank of England Governor Mark Carney and his communication skills unfavorably to Ms Yellen ..... we'll have to take that back. Not that Mr. Carney, who faces many of the same issues as his Fed counterpart but does not have to worry too much about the global impact of a UK rate hike, has noticeably improved in this regard. It's just that Ms Yellen and her board have so obviously failed to dampen down the kind of volatility and confusion that they're on record as saying they want to avoid.

Incidentally, market expectations on the timing of a Fed move as predicted by futures prices have been pushed back by recent weak data. The chances of a hike AT OR BEFORE the March Fed meeting is now rated at 49%. But of course absolutely anything is possible, and that's kind of the point we're making.