The US Fed Runs Up Against “Credibility” In The Market

The US Fed Runs Up Against “Credibility” In The Market

$DIA, $SPY, $QQQ, $VXX

US Fed officials say “gradual normalization,” meaning that interest rates will move slowly and North.

This phrase that may prove problematic if economic developments require a different response.

In its public statements and projections, US Fed officials suggest that gradual normalization would entail increasing interest rates by less than a percentage point in each of the next 3 years.

The goal is to provide markets with confidence building guidance, but this works only if the economy proceeds along the path that the officials plot and expect.

Think then about what will happen if inflationary pressures prove stronger than expected over the next year or so.

The Fed could curb inflation by raising its interest-rate target faste.

But, if it does that it faces a dilemma.

It must either break its commitment to move gradually, or move to keep inflation close to 2%. either way it will lose credibility.

Hang on, now suppose that US economic growth turns out to be weaker than the Fed anticipates, that is 180 degrees out of its current phase.

Former Chairman Ben Bernanke explains that the Fed could respond by taking interest rates negative.

Communication then becomes the obstacle.

By expressing its strong preference for normalization, the Fed has been telling investors that they can safely ignore the possibility of a reduction in rates.

Remember last week at the close of her 16 March press conference, Chairwoman Janet Yellen stressed that officials are not discussing the possibility of adding stimulus aka QE.

So to respond appropriately to an adverse shock, the Fed would have to renege on its commitment.

The Fed’s commitment not to cut interest rates could actually make it reluctant to raise them.

Markets will see each new, higher interest-rate target as a floor, further limiting the central bank’s room for maneuver.

So, if Fed officials want to maintain flexibility because they are worried about downside risks, they might choose not to raise rates at all, running a smaller risk of being forced to go back on their normalization commitment.

US Fed officials must recognize that their expectations for the economy, like all forecasts, are likely wrong.

And in that case, they should be much clearer about their willingness to make large and rapid changes in monetary policy.

Instead of talking about gradual normalization, they should stress that they are ready to do “whatever it takes + tax and license” to keep employment up and inflation under control.

Let’s see what they do…right now they are working to confuse the markets.

Tuesday, the US major stock market indexes finished mixed at: DJIA -41.30 at 17582.57, NAS Comp +12.79 at 4821.65, S&P 500 -1.80 at 2049.78

Volume: trade was light on the NYSE, with just over 800-M/shares exchanging.

• Nasdaq Comp: -3.7% YTD
• Russell 2000: -3.4% YTD
• S&P 500: +0.3% YTD
• DJIA +0.9% YTD

Stay tuned…

Paul Ebeling

HeffX-LTN

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