Wednesday, December 19, 2018

Federal Reserve & Data Dependency

The Federal reserve will raise rates by 25 bps this Wednesday at the December FOMC meeting.  This is the expected economic consensus, although market participants want rates to be lowered to boost market valuations.  While fears of slower global growth are driving volatility, the markets are noisy data in the basket of data the Fed tracks and reviews, because the Fed makes its decisions not on fears or exuberance but on the data and the documented trend of the data.

While slower growth would normally be accompanied by lower inflation, trade wars and tariffs can yield slower growth and rising prices (inflation).  Political uncertainty domestically and internationally can cause endogenous and exogenous volatility and economic instability, but economic data reflects what has happened and reacts to what will happen.  The Fed is concerned about financial stability --- not politics --- not market fears; it is data dependent while recognizing
financial risks, as can be seen in the Fed Financial Stability Report, which looks at valuation, credit (particularly corporate credit), foreign, financial leverage, and funding risks.  Powell and Brainard have both given speeches recently on financial stability.

You can see the data dependency and emphasis on financial stability in the participants comments in the November FOMC minutes.  The economist Tim Duy commented in some detail on the emphasis on data and stability in those minutes.

Duy has also thought about what data would cause the Fed to pause and it would involve a constellation of data not just one or two.  Duy posits it would take a sharp drop in ISM index growth, weak job growth, and sustained low inflation.  In analyzing  Federal reserve Vice-Chairman Clarida's speech (link in first paragraph above) on data dependency and monetary policy, Duy discusses the different alternative policy actions based on different employment and inflation data.

Despite the unpleasantness on Wall Street, the data is consistent with a rate increase in December and, at present, probably in March.  Given the growing political uncertainty and market volatility, the Fed, according to Tim Duy, may drop language about future rate increases and emphasize data dependency as well as assure they are monitoring US and global financial stability.

If financial instability manifests itself, the Fed will need all the rate cushion data driven rate increases will provide to lower rates.

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