Fed: Brainard seemed to demur from the Troika (Yellen, Fischer, and Dudley) - BBH

Research Team at BBH, suggests that their approach to Fed-watching is clear as among the cacophony of voices, the Troika of Fed leadership Yellen, Fischer, and Dudley provide the clearest signal. 

Key Quotes

“They are most often on message, and their comments have been the best indications of policy. 

Remember at the end of last summer; Dudley said a rate hike was less compelling.  This foretold the lack of hike last September.  Earlier this year, as several regional presidents were talking up a rate hike, Yellen pushed against it. 

Governor Brainard is the newest member of the Board of Governors.  Well, technically, Fischer was confirmed at the same time, but his experience is vastly superior.  Brainard has completed a little more than 2 years of her 12-year term.  This is not to impeach her comments.  They are thoughtful and well considered.  They were thoughtful and well considered six months ago too.  She has not changed her assessment, though circumstances have changed. 

First, the global risks appear to have eased.  The UK referendum has come and gone.  The global capital markets have become decoupled to a large extent from what happens to the Chinese yuan and stocks.  It is the politics of several emerging market countries (like Brazil, Mexico, Turkey, and South Africa), not the economics that has been the source of consternation by investors. 

Second, the nine-month soft-patch in which the US economy grew less than 2% appears to be ending now.  We are familiar with three regional Federal Reserve's GDP trackers.  The St. Louis Fed's and the Atlanta Fed's models point to an annualized pace of more than 3% here in Q3.  The NY Fed says the economy is tracking 2.8%. 

Third, the fact that the Fed does not have conventional monetary tools at its disposal is an argument that has been developed to encourage policymakers to gradually raise interest rates.  However, Brainard turns this argument on its head.  She suggests that the limited arsenal should make the Fed even more cautious about taking risks, such as raising rates.

Brainard argued that guarding against downside risks is preferable to preemptively raising rates to guard against upside risks.  This seems to misunderstand the purpose of raising rates.  It is not to ward off too tight of a labor market or too strong of growth or too high of inflation.  A series of several rate hikes over the next couple of years would give it the interest rate tool again. 

We can agree with Brainard that there is no hurry and the Fed should be cautious as macroeconomic relations may have changed, such as employment and inflation.  However, given the forward momentum of the economy, the improvement in the labor market, the modest upward pressure on prices, the Fed has arguably been cautious and patient.  Would a second rate hike in two years change that assessment?

We wonder too if the significance of 25 bp increase in the Fed funds target range is not being exaggerated.  The real funds rate remains below zero, which is a measure of the monetary stance, even on a 25 bp increase.  It is hard to see the impact of the December 2015 rate increase.  Three-month LIBOR has risen nearly as much due to the reforms in the US money market as it did in response to the Fed's hike.   At the end of the day, we agree with Brainard.  Monetary policy should be cautious and prudent.  A 25 bp hike does not make the Fed incautious or imprudent. 

Nevertheless, Brainard is the second Fed Governor (Tarullo being the other) that seemed to demur from the Troika (Yellen, Fischer, and Dudley).  The market downgraded the chances of a Fed hike in September.  Bloomberg's calculation (WIRP) fell from 30% before the weekend to 22%.  The CME (where the contract is traded) saw the probability falling to 15% from 24%.  For the record, the probability shift was a function of the implied yield falling three-quarters of a basis point to 41 bp. 

The US two-year note yield fell a little more than a single basis point on Monday.  The decline in response to Brainard was less than 4 bp from the 80 bp level that was seen as the pre-weekend move was continued.  The Financial Times called this a "plunge" but this is clearly hyperbolic.  Recall that as recently as the middle of last week, the yield was near 71 bp.”