Fed: The Frexit Factor

Published on February 15, 2017

With May rapidly becoming something of a base case on the timing to the next rate hike by the Federal Reserve, questions are invariably rising about a Brexit-like political risk in the two rounds of French presidential elections that bracket the May 2-3 meeting of the Federal Open Market Committee.

*** We believe the “Frexit” risk will, on balance, have a minimal impact on the Fed’s timing to its next rate hike, largely because, unlike last summer with the shock Brexit vote, Fed officials are much more confident about the resilience of the US economy that they believe is at or near maximum employment and a mandate-consistent inflation. ***

*** But perhaps more interestingly, the impact of the French elections on the Fed’s policy deliberations is probably more likely to come at the March rather than May FOMC meeting, in being used by the more hawkish-leaning Committee members to make the case for a March move to get in front of any European political risk. ***

*** That argument will add to the accent (a French one if you will) Fed officials will be putting on the critical March 10 Non-Farm Payrolls. And just as Fed officials undertook a messaging campaign in the run up to last summer’s intended rate hike, we will be watching for a similar coordinated messaging before the March meeting, especially if high profile speeches are scheduled just before the pre-March meeting blackout. ***

A Refined Reaction Function

The Fed will, of course, be keeping an eye on the potential spillover of the French election political risk into dollar inflows or treasury yields and spreads. And if there is significant market dislocation in the run up to the FOMC’s early May meeting, Fed officials will pass on any change in rate policy that could potentially add to market volatility, as they would in any similar situation, be it French elections, Brexit, or market turbulence triggered by uncertainties over the Chinese economy.

But barring immediate and excessive market volatility, the Fed’s reaction function is likely to differ from its caution on the Brexit vote on two counts.

For one, there are the lessons learned from the experiences last summer. The French election risk, like the Brexit risk, is a date-specific binary risk rather than a general overlay of risk in the way the Chinese economic uncertainties hung over the markets and Fed policy in August 2015 and January last year. It means a different way of assessing the risk and how it might be expected to influence US economic activity.

The primary concern then, as with the Brexit risk, is invariably what it might mean in an undesired or excessive tightening in US financial conditions due to potential capital flight into the dollar and treasuries. But how those repercussions might play out would be factored into future forecasts and policy adjustments rather than driving a near term policy decision.

Le Pen’s Drawn Out Opt out Process

Even if National Front candidate Marine Le Pen should win the second round, its impact on the US economy is still likely to be extended and probably making its way into the forecasting projections for the June FOMC meeting. And any impact would also have to be factored in relative to the expected larger weight of the anticipated changes in the scale of US fiscal, tax, and regulatory policies.

As it were, the feared Brexit risk to the US economy turned out to be so muted as to be hard to find in the data. And while an upset Le Pen win would be much more of an existential threat to the European Union and the Euro, its impact even on faster reacting markets may still be a long drawn out process.

Contrary to current assumptions, for instance, if Le Pen should win, she will still be unable to move quickly on a referendum to take France out of the Euro and the European Union, nor does she intend to. FN officials explain Le Pen would first go through at least six months of negotiations with the European Commission before even going to a French referendum.

And the French referendum in any case would not be a simple “in or out” vote as the British vote was last July, but for a more politically complicated drafting of a new French constitution rewriting the articles that regulate France’s EU membership, and introducing a proportional system to French electoral law.

It would in effect be tantamount to creating a Sixth French Republic, and that could take years with stops or reversals along the way.

A More Resilient US Economy

But more importantly, in contrast to last summer, the FOMC majority is much more confident about the momentum to the economy’s above trend growth and the continued tightening in the labor market, and how that point to the steady rise in inflation towards its 2% target. That means the risk management calculations this year are if anything, tipped modestly to the other side of the scale.

Through most of last year, the risk-averse FOMC was very sensitive to global developments and risks, some of it self-inflicted. Many Committee members, for instance, perhaps a majority and certainly including the Chair, were never comfortable with the four rate hike scenario mapped out in the December 2015 rate dot projections, and the violent market turbulence in January and early February only confirmed their uneasiness.

By the time of the March 2016 meeting, even more hawkish Committee members were taking the global effects into account in reassessing the pace of policy normalization. There was still a strong intention to undertake the second hike in the policy normalization path by summer, but it was waylaid by a shock NFP print that proved to be an anomaly, and of course the feared Brexit dislocations.

But equally importantly and largely forgotten, was the far more consequential reassessment by almost the entire FOMC on the estimated effective equilibrium interest rate that culminated in the dramatic marking down of longer run neutral estimates in June and September.

At this point, Fed officials are no longer marking down the longer run neutral estimates and are in fact mostly looking to how soon they may start marking those estimates higher. That, in turn, has a lot to do with the change in the assessment of the risks in mis-timing a move to remove a little more accommodation in the system. The discomfort is in being too near for comfort to the Zero Lower Bound, but it is a diminished calculation in the larger scheme of things.

And that is especially the case in the current base case outlook for US growth for continued above trend that will warrant the two to potentially three rate hikes this year. And some Fed officials will no doubt hint at the potential need for a fourth rate move this year — which we think is unlikely to come — if the Trump Administration and Republican-controlled Congress come anywhere near delivering on tax cuts and a coherent spending plans in the fiscal year 2018 budget.

If anything, then, the rate risk is rapidly shifting to the upside, not downside as it was in the first half of last year, and that has to be kept in mind when weighing the potential impact of the French and European political risk.

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