It’s what the Fed says that matters

If there is to be any change at all to US rates this year, the Federal Reserve knows it will have to provide a clear warning well ahead of the event. (AFP/Karen Bleier)

The US Federal Reserve Board’s two-day Open Market Committee meeting starts tonight with no expectation among Fed watchers or within markets that the Fed will shift US interest rates. Thus, what it says may be more meaningful than what it doesn’t do.

It is “may” rather than “will” because the markets have learned to distrust the Fed, which last year foreshadowed a number of rate hikes and eventually settled for one. At the start of this year it was guiding towards four rate rises. There have been none.

Where there used to be significant anticipation and market volatility ahead of the FOMC meetings now the markets tend to ignore them, knowing that the Fed keeps finding fresh excuses to sit on its hands even though US economic data — and the Fed has said it would be data — driven — would appear to support another 25 basis point movement in its policy rate. Recent US employment, consumer spending and manufacturing data has been solid.

At its June meeting the justification for inaction was the looming Brexit vote. After the initial turmoil in response to the shock outcome, markets have settled, with the US stock market powering along.

In many respects the problem confronting the Fed, which appears to be increasingly sensitive to potential market responses to its decisions, is one of its own making.

Its quantitative easing programs, which ended last year, and the ultra-low official rates it has maintained since 2008 have dramatically inflated asset prices and compressed risk premia.

Those programs have driven remarkable growth in US dollar-denominated borrowings, particularly within developing economies. They have also spawned a plethora of highly-leveraged cross-border carry trades.

The result is that markets, and the global economy, is now acutely sensitive — and vulnerable — to movements in US rates and, more particularly, in the value of the US dollar.

Central banks in other economies are running even more aggressive unconventional monetary policies to try to depress their currencies relative to the US dollar and improve their economic competitiveness — the speculation of another imminent Reserve Bank cut to Australian official interest rates is driven mainly by the strength of the Australian dollar.

Any slight shift in perceptions of the likelihood of a US rate rise generates volatility across all financial markets and a tide of funds flowing either towards the US (in anticipation of a rate increase and stronger dollar) or away from it (in the belief that there will be no rise and therefore no change in the value of the dollar).

Thus, if the US were to raise rates, even a smidgen, the Fed risks an overly strong appreciation in the value of the US dollar.

That could threaten to depress US economic activity, ignite volatility in financial markets and create an inadvertent and potentially destabilising tightening of financial and economic conditions elsewhere because of the impact on US dollar-denominated liabilities outside the US and the availability of US dollar-denominated funding outside the US.

At the moment, the markets are betting that the Fed will remain frozen by its fears of the flow-on effects of even a 25 basis point rise. The markets are ignoring the Fed’s June projections of two rate rises in the second half of the year, completely discounting any rate rise before December, with a December rise a 50:50 bet.

The Fed’s messaging and signalling has been inconsistent and driven by its concerns about the likely market reaction — perhaps because the markets responded quite violently to the one 25 basis point rate rise last December, the first since the financial crisis. The US sharemarket fell almost 13 per cent from its December peak to its early-February lows.

With Brexit behind it, the markets calm and US economic data positive, the Fed will have to find a new reason for inaction this week. The markets appear to have little doubt that it will.

If Janet Yellen and the rest of the FOMC do want to sneak at least one rate rise through in 2016, however, they will need to provide some guidance soon that provides an early warning signal to markets and borrowers that there is another (small) rate rise on the horizon.

They will want to avoid blindsiding those who have become quite cynical about the Fed’s appetite for even a cautious move towards normalising US rates and starting the effort to try to reduce the potentially destructive levels of US dollar-driven distortions within a global financial system addicted to low rates and US dollar funding.

The Bank for International Settlements has said that the stock of US dollar-denominated debt of non-banks outside the US is nearly $US10 trillion. If the US dollar rises, the cost of servicing and repaying those borrowings will also increase and access to new US dollar funding will decrease.

BIS staff have also described a major change in the relationship between financial markets and real economies since the financial crisis. Real economies are responding to developments in financial markets, rather than markets responding, as they once did, to developments in real economies.

The Fed’s acceptance of the elevated importance of financial markets within its decision-making is why the language that comes out of this week’s meeting will be more significant than the action, or lack of it. If there is to be any change at all to US rates this year, it knows it will have to provide a clear warning well ahead of the event.