On Monday, a combination of domestic and international factors contributed to a significant reassessment by market participants of the probability of a Federal Reserve interest rate hike in March. Now the markets are pricing in a more realistic probability of 52 percent, up from less than 40 percent last week. Where this probability assessment goes next increasingly depends on a single data point, which could also fuel a gradual reorientation of the Fed’s approach to monetary policy and how the U.S. central bank interacts with markets.
Market expectations of a March rate hike were boosted by a clarification by Robert Kaplan, the president of the Federal Reserve of Dallas and a voting member of the policy-making Open Market Committee. In referring to previous signals from Fed officials that the central bank would likely raise rates “sooner rather than later,” Kaplan said this would imply a hike in the “near future” -- this on the basis of stronger economic growth in 2017 and the need to lower the risk of monetary policy falling behind the curve on inflation.
Rate sentiment was further influenced by signals from the White House that President Donald Trump’s first budget would include a substantial and “historic” increase in defense spending of $54 billion.
Global conditions also played a role in the market re-evaluation. After a string of record negative interest rates in Germany last week, 2-year German government bonds found their footing, at least for now. This alleviated the considerable downward pressures on U.S. yields.
Nonetheless, the higher probability of a Fed hike still doesn’t make it a done deal, and rightly so; and this is not primarily due to heightened political risk in Europe.
Judging from the insights of Fed Chair Janet Yellen and some of her colleagues, the FOMC would need stronger wage-growth data to feel comfortable raising rates for what would be only the third time in 10 years. As a result, the jobs report for February, which will released March 10, will have an important, if not deterministic, influence on what the Fed does when its top policy-making committee next meets on March 14-15.
A green light from the wage data would do more than significantly increase the probability of a March rate hike. It also would allow the Fed to slowly evolve away from its tactical posture and toward one that involves more strategic consideration.
Since the eruption of the global financial crisis in 2008, the Fed has adopted a highly “data dependent” approach to policy making. The fact that the crisis took Fed officials by surprise, together with a recovery process that has been far from usual and coupled with repeated growth/inflation forecasting errors, have undermined the Fed’s understanding of the economy’s behavior and the effectiveness of its analytical models, especially the historically-calibrated ones. The Fed became a hostage not just to high-frequency economic data (and the unavoidable “noise” that accompanies them, including some large subsequent revisions), but also to markets. Rather than lead markets, the central bank fell into the habit of following their short-term orientation.
Should the next jobs report open the way, the Fed could return to a more proactive strategic stance. In addition to countering excessive short-termism, this new orientation could provide a new policy anchor, especially when other elements of policies go from agonizing paralysis (due to congressional gridlock) to potentially significant change as will likely be illustrated by Trump’s speech to a joint session of Congress on Tuesday evening.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Mohamed A. El-Erian is a Bloomberg View columnist. He is the chief economic adviser at Allianz SE and chairman of the President’s Global Development Council, and he was chief executive and co-chief investment officer of Pimco. His books include “The Only Game in Town: Central Banks, Instability and Avoiding the Next Collapse.”
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