Fed: The EM Reaction Function

Published on January 24, 2014

Federal Open Market Committee members are in the black out period, hunkering down in the run up to next week’s two day meeting, so it is a bit difficult to assess how today’s volatility and risk off trading will play, if at all, into the statement Wednesday afternoon. That said, a few points are worth making:

*** The most immediate and obvious question is whether the EM volatility continues to worsen or turn more broadly into a general risk-off flight out of EM and other risk assets back into safe haven assets, and if so, would the FOMC pause on its taper? But at this juncture we  think the Fed will be very reluctant to pause the taper next week, whatever the reason, as the reaction function from here is likely to be built around the forward guidance on rates rather than the taper itself. ***

* The causes of the volatility this morning are clearly domestically-driven in those EM countries most affected – Argentina especially, and Turkey – and will be seen as unrelated to the primary driver to the taper, namely, the “changing of the mix”in the Fed’s extremely accommodative policy path.

* So for now at least, the volatility will be seen as a consequence of leveraged long equity/short fixed income positions built around the expectations of a stronger dollar and US economy being forced into a rapid unwinding, but which will soon stabilize. In other words, it reflects a market adjustment that falls well short of spillover into the outlook for the real economy that would or should alter the present policy path.

* And even if, and that is a big if, the volatility persists and substantially worsens into a broader risk-off flight into safe haven assets, the FOMC’s first instinct will still be to adopt the least disruptive policy stance in its January statement, and that again will probably mean steering clear of any deviation from the current “measured” taper in the flow of its bond purchases that is, after all, only intended as an adjustment in the mix of its ample accommodation, not a change or even modest withdrawal of accommodation.

* So our base case expectation for the January statement remains for another measured $10 billion a month taper in the bond purchases to $65 billion to be affirmed. Because of the complexity of the considerations that have to go into any changes in the formal guidance language, we likewise expect a minimal change in the statement, save for updating the outlook, and for little to no change in the guidance language. If it ain’t broke – yet – don’t change it.

* That, however, has now changed with the debate on both the guidance and financial stability being brought forward into next week and especially into what looks to us what will be a pivotal March meeting. As we wrote in our most recent report (1/22/14. “Fed: Towards a Post-Threshold Framework”), the drop in the headline unemployment rate to 6.7% means they know they need to revise the guidance sooner rather than later.

* And even if the EM volatility is short-lived, it too will figure large in the two days of discussions next week. Our sense is that Fed officials hope enough progress can be made towards a consensus on both in January that can shape post-meeting public remarks as well as the thrust of the new Chair Janet Yellen’s first Humphrey Hawkins testimony in the second half of February (as far as we know, the date has not been fixed yet).

* It is early days on the revisions to the guidance, but as we noted previously, the building sentiment is for a shorter and simpler statement with more of a purely qualitative forward policy guidance beyond the current 6.5% unemployment and 2.5% safeguard inflation thresholds.

* That seems likely to point to a greater weight in the guidance being given to the inflation mandate, and an accommodative low rates policy that should lead to inflation rising back to and temporarily just beyond its medium term 2% mandate (that will be reaffirmed next week in the Statement of Longer Run Policy and Monetary Policy Strategy).

* So again, short of today’s volatility worsening and clearly spilling over into the stability of the US markets, the FOMC should have the luxury of staying the course with a steady as she goes statement next week. But the meeting will start a complicated two part debate over the effects of EM and risk asset volatility and spillover and how to incorporate such financial stability (or lack thereof) into the current policy path, as well as how to revise the Fed’s forward policy guidance in light of the headline unemployment rapidly nearing or even crossing the 6.5% unemployment threshold.

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