The most pressing question this morning is easily the likely impact of China’s surprise devaluation on the Federal Reserve’s current policy path.
*** Our sense is that China’s devaluation, on balance, is still unlikely to significantly alter the base case arguments in favor of a “sooner” first rate hike at the upcoming September 16-17 Federal Open Market Committee meeting. Instead, what impact there is, is more likely to show up in an even more gradual and shallow rate tightening trajectory in the outer years of the forecasting period out to 2018. ***
Limited Impact in September
First, the near and longer term impact of a major shift in macro drivers, be it oil prices or China’s exchange rate changes, takes a while to get incorporated into the Fed staff’s forecasting models and projections. Staff work across the Fed system is well into the forecasting process, and while there may still be plenty of time to make adjustments in their assumptions, if the past provides any guide, initial projections of the impact by the time of the September meeting may be somewhat limited.
For instance, while the market’s initial reaction is to focus on China’s renewed export of disinflation, the Fed will be taking a broader view, trying to assess the potential effects on Chinese domestic demand and growth, and its effects on global growth and how it may play back into US growth further down the road. That may, to some extent, offset the disinflationary effects, especially if the Fed takes Beijing at its word that this is a one-off adjustment to allow the exchange rate to be more market driven from here — even if the meaning of a “market driven” yuan may still see some further “free market” albeit gradual currency depreciation down the road.
Those initial limited effects, then, will also have to be weighed against the broader “sooner” arguments for a start to policy normalization that go beyond just the near term inflation path. The most important of those is the desire to “protect” the assumed very gradual pace of rate hikes to avoid the need to raise rates rapidly and potentially triggering severe market dislocations or a derailment of the “good enough” recovery towards full employment (see SGH 8/7/15, “Fed: Good Enough” and SGH 7/23/15, “Fed: July Meeting Signals”).
So we think the consensus of a Committee majority is still leaning strongly towards a September start to policy normalization. And along those lines, we would caution against any dovish interpretation to the remarks yesterday by Federal Reserve Bank President Dennis Lockhart or especially the missed opportunity of the wire service interview with Fed Vice-chairman Stanley Fischer. They were anything but, and Lockhart in particular was simply putting his earlier interview with the Wall Street Journal into context, as he tried to explain to reporters after his speech.
A Slower, Flatter Rate Trajectory
There is, however, little question the Fed staff will nevertheless be looking as closely as the market is on how another wave of Chinese-driven global disinflation and a stronger dollar may put renewed downward pressure on US goods prices next year.
And even if the Fed staff are not as quick to jump to conclusions as the market is, it is worth noting the FOMC’s “reasonable confidence” in core inflation measures beginning to rise back towards mandate-consistent levels next year is based on the full employment effects of an upward cost-push of higher wages on services inflation and the absence of the downward price pressures of the stronger dollar or sharply falling oil and energy prices on goods prices to allow for that slow rise in core price measures.
If the latter assumption is put into question by the Chinese devaluation, it could push the Fed staff’s projected rise in core inflation out even further from sometime in early or mid-next year towards the end of the year or even into 2017. (As a side note, it will be interesting to see how the China syndrome of falling inflation will work its way into the discussions on inflation dynamics at Jackson Hole in a few weeks).
For now, Fed officials tend to dismiss the various factors keeping inflation low as “transitory,” but after a while, the accumulated effect of yet another “transitory” factor may begin to weigh down the trend price projections. And with US core inflation already persistently so low, there is no question this will lend support to the “later” camp arguments to avoid a premature rush to start policy normalization.
But again, it is our sense that the majority consensus for a sooner rather than later start to policy normalization will remain intact by the time the FOMC sits down for the September meeting. And what’s more, it seems more likely to us that this China syndrome of renewed downward pressures on global goods prices will play out in the pace of subsequent rate hikes. Wherever the FOMC blue dots plots were in June, a good bet is for them in the September dots to look even lower and flatter.
Dudley Speaking Tomorrow
And one last note is that Federal Reserve Bank of New York President Bill Dudley is speaking tomorrow in Rochester, New York on the economy, or at least the Rochester economy, but he will be taking questions from national reporters in tow for the speech. He is almost certain to give at least some nod to a stronger dollar as one of the factors the Fed is closely monitoring.
He did before, but that was when the dollar was appreciating at a far faster pace than now, and we would be surprised if he didn’t frame any dollar remarks with the standard caveat that it is just one of many factors going into the policy decision in September.
And so we would caution against reading too much into anything he says about the dollar, as we do not sense China or any other recent news on the dollar or commodities since the last FOMC is materially moving the policy needle. At least not yet.