If securities markets can be likened to unruly and spoilt toddlers (which they can be), and the Federal Reserve can be likened to a stressed and firm but benevolent parent (which it hopes to be), Janet Yellen has passed her first big parenting test.
Her task this week was to inculcate some discipline, by gently raising rates to head off what looks like the beginning of inflationary pressure in the US, without triggering a market spasm that would endanger financial stability and the economy. As a challenge, it can be likened to removing an iPad from a child’s grip without a meltdown.
She achieved it. We have the first Fed rate rise in almost a decade, executed at a time when many significant voices were arguing against it, and the market response was negligible. The Fed’s message in advance had been clear, the market heard what it had expected, and as a result little happened.
Not only that, after several dissensions by Fed governors this year, the vote to raise rates was unanimous, showing that Ms Yellen can exert some calm persuasion over her colleagues as well.
Where this leaves the market is another question. In the short term, the iPad has been removed from the kids without tears. Ms Yellen’s words to accompany Wednesday’s increase, emphasising that rises will be gradual from here, and that rates will continue to be lenient for well over a year, did the trick.
But reasons for disquiet remain. Markets may have swallowed this, but they were not in robust health to begin with. High-yield credit in the US remains in a parlous state, although the fact that a number of big investors decided it was time to buy after the weekend is encouraging. Oil is still falling. The US stock market — despite a rally during Ms Yellen’s press conference that brought the S&P 500 into positive territory for 2015 — remains becalmed, as it has been for a year.
And it is not at all clear that the markets and the Fed understand each other, even now. Ms Yellen’s message was, in fact, a little firmer than markets had implicitly expected. That has yet to sink in.
Most importantly, there is the vexed issue of the dot plot — the graphic that the Fed publishes every quarter showing each FOMC member’s estimate of the future path for the Fed Funds rate as a dot. Several governors did cut their estimate of how fast rates will accelerate from here. But the bottom line remains: their median estimate is for four rate hikes next year, bringing rates to 1.5 per cent.
Yet the Fed Funds futures market, which investors use to hedge rate rises, barely sees any chance of the Fed’s suggested four rate hikes, and is priced for no rate rise until June. That would be an exceptionally dovish tightening cycle, particularly as politics could well make it harder for the Fed to raise rates in the months before November’s US election.
In short, the market and the Fed have still not joined up the dots. Investors are still, on balance, fighting the Fed by betting that inflationary pressures (which are most likely to come from the labour market) are not as strong as the Fed itself believes. Joining those dots will inevitably require fresh doses of market volatility. There could still be tears before bedtime.
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