Westpac: Fed to hike in September

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From Westpac’s Elliot Clark:

CaptureThe volatility apparent in the Chinese stock market; concerns over global growth; and an impending ‘first hike’ by the FOMC come September have all weighed heavily on US financial markets in recent weeks. From peak to trough, the S&P500 abruptly fell to be down almost 15% at its weakest point.

A more cautious stance from centrist FOMC voter Lockhart on a September start to policy normalisation highlights that this market volatility did not go unnoticed amongst FOMC members, clearly impacting their confidence in forging ahead with September. NY Fed President Dudley also showed caution, noting that a September rate hike “seems less compelling” than a few weeks ago. However, what Dudley then went on to say about the recent volatility is more valuable with regards to the outlook for policy. Specifically he highlighted that it was not the external and financial market developments themselves that were significant for policy, but rather because “international developments and financial market developments… can impinge and affect the economic outlook”.

Clearly then, when assessing the outlook for policy, it is not appropriate to ignore financial market volatility, nor to get swept away by it. It needs to be put into context, both with respect to the scale of said volatility and, more importantly, the economy.

While abrupt, the recent declines in the S&P500 are insignificant compared to the rally off the post-GFC lows. After this week’s rally, the net change from peak is around 7.0%. That is but a fraction of the 200%+ rally off the post-GFC lows, and still leaves the S&P500 near its post-QE3 level – well above previous cycle peaks. A further deterioration could change the calculus; but given the rebound, the recent weakness seems contained.

With regards to the real economy, it is not possible to assess the impact of market volatility in real time. However, what we can do is consider the degree of strength in recent data, and in so doing the probability of the economy being materially affected.

Above-average consumer confidence; strengthening wage expectations; robust consumer credit growth; and an unemployment rate nearing its full employment level are all supportive of strength in consumption in coming months. What’s more, the seemingly yet-to-be spent windfall from lower oil prices and continued house price gains are additional positive factors which could further bolster demand. Household demand therefore has strong support.

For investment, the question is more complex. On a GDP basis capex is soft while durables goods orders have been weak. In part this is a function of the low oil price and strong USD (both accentuated by market volatility). But there is also reason to believe that the current emergency settings of monetary policy are to the detriment of real investment. As is made clear by debt and equity issuance data from the flow of funds, listed firms continue to borrow in large part to improve their financial efficiency and return on equity – primarily through equity buy backs and M&A activity. This entrenched trend is arguably a function of firms not being confident enough in the outlook for end demand to take a risk on capacity expansion – at least in the domestic operating environment. To the extent that commencing the normalisation process would evoke a sense of confidence in the outlook and a recognition that top line growth is necessary, the hoped-for response would be greater investment in capacity; further job creation; and (with time) revenue and income gains. Certainly this was a view expressed by some of the foreign central bankers attending the Jackson Hole event. Of course, they could be ‘talking their own books’ in terms of exchange rates!

I’ve often found myself in agreement with Elliot in the past but this is wrong to my mind. There is no evidence of a turn in US consumption. He’s simply assuming it. There is oodles of slack still in the labour market and zero risk of inflation with mounting risks of deflation.

With risks to growth rising around the world owing to falling commodity prices and emerging markets troubles the Fed will wait. There’s no upside going to early, it’ll destroy them it they’re wrong.

And they are.

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About the author
David Llewellyn-Smith is Chief Strategist at the MB Fund and MB Super. David is the founding publisher and editor of MacroBusiness and was the founding publisher and global economy editor of The Diplomat, the Asia Pacific’s leading geo-politics and economics portal. He is also a former gold trader and economic commentator at The Sydney Morning Herald, The Age, the ABC and Business Spectator. He is the co-author of The Great Crash of 2008 with Ross Garnaut and was the editor of the second Garnaut Climate Change Review.