Is the Fed done tightening?

Westpac doesn’t think so:

Ahead of the January meeting, we outlined the difficult challenge facing the FOMC. On the one hand, employment growth had firmed (continuing the downtrend in the unemployment rate) and domestic demand growth remained robust. On the other, financial conditions had again taken a turn for the worse, with market participants clearly concerned over the emerging market growth story; commodity prices; and the chances of further market declines.

Given this apparent tension, it was necessary for the FOMC to take greater note of the risks to the outlook in their January statement, albeit while not walking away from the Committee’s medium-term expectations for growth; inflation; and the stance of policy. This is exactly what transpired.

The January statement commenced by noting “labor market conditions [had] improved further even as economic growth slowed late last year”, pointing “to some additional decline in underutilization of labor resources”. A slight downward revision to the near-term growth view was of little consequence, with “Household spending and business fixed investment” now seen to be “increasing at moderate [rather than “solid”] rates in recent months”. Housing was said to have “improved further”.

The view on domestic demand therefore remained constructive overall, with the onus for the expected deceleration in Q4 growth instead falling on “soft” net exports and slower inventory investment – neither of which are core concerns for the FOMC.

The inflation discussion was, on the whole, also little changed from December. While “Market-based measures of inflation compensation [had] declined further”, “survey-based measures of longer-term inflation expectations [were] little changed”. More importantly, on the outlook: “Inflation is expected to remain low in the near term… but [still] to rise to 2 percent over the medium term as the transitory effects of declines in energy and import prices dissipate and the labor market strengthens further”.

As expected, the most significant change to the policy statement came in the discussion of the risks to the outlook.

In December, “taking into account domestic and international developments”, the “Committee [saw] the risks to the outlook for both economic activity and the labor market as balanced”.

Come January, this balanced risk view is replaced with the much more open-ended: the “Committee is closely monitoring global economic and financial developments and is assessing their implications for the labor market and inflation, and for the balance of risks to the outlook”.

This revision is best regarded as implying that the Committee is aware that further downside risks could eventuate. If that did occur, then policy would accommodate. But equally, these risks may not eventuate; and if that is the case, then the Committee would be justified in continuing the normalisation process through 2016, as their current forecasts imply.

Overall then, this is a statement which does little to alter our view on the most likely course of action by the FOMC in 2016. The run of data between now and the March meeting will prove critical, as will financial markets’ reaction to the data flow and news from offshore. On the basis of our own and the FOMC’s forecasts, there will be cause to continue the normalisation process through 2016. Yet, as ever, each decision will remain data dependent to the day it is made, bearing close watching of market dynamics and Fedspeak.

Too sanguine for me. The Mining GFC is going to keep pushing until the Fed openly acknowledges that it is already finished. Thus the risk are now tilted towards no more hikes. Certainly the Westpac view of four hikes this year is now obsolete.

The US economy has got domestic momentum in housing, cars and services so I do not expect some sudden stop and Fed reversal to more easing. Rather, my working hypothesis is that as markets pull down share prices over the next few quarters, the consumer will come under more strain from a negative wealth effect which will move the Fed to neutral.

However, at some point, we still expect the Mining GFC to throw up a serious debt panic and force the Fed to ease.

But by then the damage is done and being behind the curve, as well as chasing other central bank easings, a slowing China, EM crisis and European recession, it will have a lot of work to do to catch up.