Fed holds its aces

What are the global ramifactio­ns of the US Federal Reserve’s decision to hold interest rates and start unwinding stimulus?

Dünya Executive - - COVER PAGE - By Sant Manukyan

How will the Fed’s decision to hold interest rates affect Turkish, global economy?

1 Why was the Fed decision seen as a surprise?

For the majority it was a surprise due to the consistenl­y low inflation rates. However, Chair Janet Yellen has stressed the transitior­y nature of the decline and I believe did the right thing by keeping the door open for a third rate hike in December. Throughout the year investors have been at odds with the Fed. Not many people were expecting a March hike either even though the December 2016 dot plot was indicating a hawkish Fed.

2 How hawkish were the Fed’s statements?

With no significan­t economic revisions or change in the dot plot, they were as hawkish as possible. Had the Fed hiked or changed the previous arrangemen­ts for the balance sheet reduction it would have been a total surprise but the current economic conditions would not justify such a move. By being realistic, Yellen has acted hawkish enough to align market expectatio­ns with her own.

3 Are the Fed’s inflation and growth expectatio­ns realistic?

Yes, but for inflation to gain momentum tax cuts and infrastruc­ture spending are required. Future expectatio­ns and the current inflation rate are low. Given the low growth rate following the 2008 crisis and demographi­c changes it is hard to see where the inflation would come from unless additional stimulus is introduced. For the last two decades the PCE has rarely been above 2% for consecutiv­e years.

4 What is the possibilit­y of negative developmen­ts being realized?

Even though I don’t expect a recession in 2018 if the Fed is hiking more agressivel­y than it should, and we are seeing some slowdown in C&I loans, the economy may suddenly stop. Coupled with a quantitati­ve “tightening,” the Fed might be pushing on the breaks too hard. An overall slowdown is due by 2019 and we cannot dismiss geopolitic risks or negative developmen­ts in foreign economies.

5 To what extent have the markets believed in the Fed?

They still don’t. December is not the only detail. Markets still think there will be only two hikes until the end of 2019. They can not be blamed. As VP Stanley Fischer has resigned and Yellen is about to leave, the Fed in 2019 will be very different to the Fed now. Will the new chair be a hawk? The Fed has consistent­ly been proved wrong by the markets for the past two years, so people are still willing to put their cash on market expectatio­ns rather than the Fed’s dot plot.

6 How will the system of balance sheet reduction work?

It will be a passive reduction, i.e. the Fed will not reinvest proceeds. This fact is a given and no longer matters. What counts is who will fill the space the Fed is slowly but surely leaving and what is the optimal balance sheet size for the Fed? The Fed argues the reduction of assets will not put any pressure on yields and that it is not a tightening policy. But the pivate sector might ask for higher yields before demanding more US bonds and if buying bonds are named “quantitati­ve easing.”

7 How will the Fed’s decision affect other big central banks?

A tightening Fed would support the greenback and make life easier for both the ECB and BOJ, two major banks seeking weak curriencie­s. The ECB is increasing­ly ready to move the stimulus out of the markets so we have two major banks tightening and only the BOJ persuing an expansiona­ry policy. If more banks, such as the PBOC, join the Fed, ECB markets will need to reprice their assets accordingl­y. Global yields are still low and a crowded trade. German two-year bonds are trading at –0.70% whereas the ECB is about to claim victory against disinflati­on. Someone must be wrong.

8 How will stocks, gold and oil perform after the decision?

Banking stocks will outperform for a while. As for oil, investors are more interested in the future fate of the OPEC/nonOPEC production cut agreement in 2018. Unless a minimum six-month extension is agreed on oil prices, it will be hard to maintain current levels. Another extension would support the prices and push WTI towards $55. Assuming a Fed hike in December, gold will decline. Tension with N. Korea did support prices for a while but, unless markets fear real action, investors will not demand more gold.

9 What impact will this policy have on emerging markets?

Logic suggests the US yield will head north. That might put pressure on EM’s and force EM central banks to react. A hiking Fed means a strong economy, increasing wages and stronger demand, which is good for EM’s with close economic ties to the US. A stronger dollar and higher yields might put a dent in portolio flows to counties like Turkey but as long as the Eurozone keeps current pace Turkey will maintain its growth path.

10 Do the expected changes in Fed administra­tion affect monetary policy?

Uncertaini­ty about the next president creates uncertaini­ty about future Fed policies. John Taylor, Glenn Hubbard and Kevin Warsh are well known, and Republican candidates are relatively more hawkish. Whereas Gary Cohn, a non-academic and veteran Wall Street pro, is a black box for the markets. The new chair or the extension of Yellen’s term does have the potential to rock the markets.

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