FED´S BEARHUG WON´T BE SO TIGHT / THE WALL STREET JOURNAL

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Fed’s Bearhug Won’t Be So Tight

The market is bracing for a tightening cycle, but it isn’t likely to look like past rate increases

By David Reilly

March 11, 2015 1:46 p.m. ET

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Fed Chairwoman Janet Yellen needs to convince markets that what is typically a bad thing can actually reflect improving economic conditions. Photo: Reuters

 

 

The past won’t necessarily be prologue, at least when it comes to the looming Federal Reserve interest-rate tightening cycle. Convincing markets of that will be a tough sell for the Fed, though.

Witness the market’s sour reaction to better-than-expected February jobs data and the dollar’s continued strengthening, rapidly approaching parity with the euro. In some ways, this shouldn’t be a surprise: Risk assets have soared in recent years as the Fed pumped liquidity into the financial system; there will be a natural reversal as the central bank executes a policy turn.

Yet market gyrations also seem to presuppose the Fed is about to embark on a typical tightening cycle. It probably isn’t, and that means markets may overshoot.

In the past, when the Fed began to raise rates it was to cool an economy showing signs of overheating. That isn’t the case today.

Instead, the Fed is looking through the prism of an unprecedented period of near-zero interest rates and a large expansion of its balance sheet to about $4.5 trillion. It seeks merely to get rates on a more-normal footing.  

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So the Fed’s thinking will be shaped by its perception not of whether the economy is too strong, but whether it is strong enough to dispense with extraordinary support. The Fed isn’t trying to put on the brakes.

That flies in the face of how investors usually think about tightening cycles, so prior ones may not provide useful guidance on what follows.

For the Fed, this presents a unique communications challenge: It needs to convince markets that what is typically a bad thing can actually reflect improving economic conditions.

This won’t be easy. Markets have become accustomed, even addicted, to supereasy monetary policy. The Fed and Chairwoman Janet Yellen have already grappled with how to guide market expectations in terms of how they even prepare to consider raising rates.

An imminent Fed move is doubly confusing because there doesn’t appear to be a threat of rising inflation. The core measure that the Fed looks to was most recently at 1.3%, well below its 2% target.

Meanwhile, inflation globally is worryingly low, prompting central banks elsewhere to undertake their own extraordinary easing campaigns.

That inflation expectations remain subdued argues for the Fed, when it does decide to begin raising rates, to do so at a far more cautious pace than in the past. And policy makers will want to take special care to gauge market reactions because no one has experience of a true shift from such extraordinary policy to a normalized rate environment.

At the same time, the soaring dollar poses a rising economic headwind. The U.S. Dollar Index is at its highest level in 12 years.

So, looming Fed rate increases aren’t likely to be abrupt or persistent, in the way they were in the middle of the last decade or in 1994. Instead, Fed moves may be separated by long pauses, and interest rates’ eventual resting place may be well below what markets would normally expect.

Until the Fed can convince investors of that, U.S. stocks and other risk assets will be in for a rough time. But, longer term, the ride may not prove as jarring as investors would expect.