The Federal Reserve meeting this week will be less noteworthy for what the central bank does than for what it says about the future path of rates. With the traditionally most dovish voices on the Federal Open Market Committee now sounding notably more hawkish, policy makers are likely to try harder to nudge market expectations up to price a steeper path of rate hikes.
Moving in that direction would improve the relative attractiveness of Treasury bonds and the dollar, even as it would highlight the growing economic and policy divergence between the US and other advanced countries. Both outcomes have consequences for investors in stocks and other asset classes.
The Fed will hike rates by 25 basis points on September 26. The decision will provide a vindication of the bank's decision not to react to problems elsewhere in the world at previous policy meetings. The rate increase will point to the Fed's continued progress toward fully meeting its dual mandate, based on continued strong monthly job creation and historically low weekly jobless claims data, as well as a wider set of indicators that support the target of 2 per cent inflation, including the latest wage-increase numbers in the August jobs report.
The central bank's decision won't be a surprise to financial markets, which have already comfortably priced in what would be the eighth rate hike since the Fed embarked on this post-crisis cycle in December 2015. But that consensus does not extend to the future level of rates. Markets continue to feel that the Fed will end up pursuing a path that is less hawkish than the one policy makers have already signaled through their “dot plots” and some of their public remarks.
I suspect that one of the Fed’s goal this week will be to nudge market rate expectations higher. It will seek to do so in a way that doesn't derail US economic momentum and is consistent with medium-term stability.
To that end, several Fed officials have already come out individually to make a stronger analytical case for a more aggressive path of future hikes. One of the more notable voices is Lael Brainard, who has traditionally been viewed as one of the most dovish members of the FOMC.
In a speech last month at The Detroit Economic Club, Ms Brainard described the operational concept of the neutral rate, which many regard as the North Star for the equilibrium Fed funds rate. She said the short-term neutral rate, which will guide better interest rate policy in the next few quarters, is likely to be above the longer-term rate. That would solidify the case for rate hikes that exceed current market expectations.
Because this more aggressive rate path would reflect a stronger economy, its pursuit should not derail economic momentum nor pull the rug out from under risk assets. That policy would also be more consistent with genuine and durable financial stability, an issue that the current Board of the Governors under the leadership of Chair Jerome Powell may stress more than previous boards led by Janet Yellen and Ben Bernanke. In the process, the Fed would highlight the growing divergence in economic performance between the US and the other major advanced countries.
Market participants will find it increasingly difficult to ignore the broadening set of Fed signals pointing to the more aggressive path of rate hikes. By converging closer to the Fed policy guidance, the markets’ implied path of future rate hikes would end up repeating a pattern that played out in 2016 and 2017: Start more dovish than Fed guidance, only to validate it later.
This, along with the lessening influence over time of “non-commercial” buyers (including pension funds matching more of their long-dated liabilities through bond purchases, and the spillover effects of the large-scale asset purchase programs of the European Central Bank and the Bank of Japan), would call for higher yields across virtually all Treasury maturities. It would also place considerable pressure on the yield differential between US and German bonds, which is already high in historical terms, ending last week at more than 260 basis points for 10-year maturities. With that comes the prospect that bonds could attract some of the more risk-averse investment flows away from stocks, and place possible upward pressure on the dollar.
All of this shows that widening economic and policy divergence is one of the most important “top-down” issues for investors in stocks and other asset classes. For it to prove consistent with further gains in world stock markets and other risk assets, two developments are necessary to enable a process of convergence from below -- that is stronger growth in the rest of the world. And both fall far outside the Fed’s sphere of influence. Europe and Japan would have to take more comprehensive policy measures to bolster their actual and potential growth rates; and emerging economies need to be able to navigate a further tightening in their external financial conditions.