What did we learn from the Federal Reserve minutes on Wednesday? Taken at face value, all the minutes said is that most FOMC members thought that June could very well be a good time to hike, depending on how data came in between meetings.
But taken in consort with recent Fed speeches, the Fed pretty much has to hike. Otherwise they will lose what little credibility they now have.
First, let's briefly talk about how we got here. When the Fed first hit the zero bound on short-term interest rates, one strategy for creating additional stimulus was to give explicit "forward guidance" that rates would stay low for a long period of time. This helped the market understand that the Fed wasn't going to start hiking given relatively mild improvement in data. There also wasn't much risk to this strategy. The Fed knew that economic conditions couldn't possibly improve enough over a short period to warrant hiking. So, they could afford to say definitely that there wouldn't be any hikes for a long period of time.
There were a few ways they used to communicate this, but the core message was the same: it doesn't matter what the data say, we aren't hiking.
The Fed has had an extremely difficult time weaning itself off forward guidance. What they really want now is the flexibility to hike or not hike at any given meeting. They tried simply telling us that they were going to be "data dependent." That might have worked, except that they don't seem to have a consistent set of data they are watching, nor a consistent target for those data. They talked a lot about hiking in "mid-2015," but took a pass in both June and September despite the core economic data seeming to be in line with their stated criteria. They eventually hiked in December 2015 and, to this day, I'm not sure anyone really understands why.
With this in mind, let's now consider what's happened this week. As I said above, the minutes from the Fed's April meeting clearly suggest that June might be the right time for a second hike. The minutes read a little stronger than just that June was a "live meeting." But at the very least, the Fed wants us to think that a rate hike is a distinct possibility, but not a guarantee. It isn't just the minutes. Every Fed speaker over the last 10 days or so has gone out of their way to say that June was a good time to hike. This includes some pretty dovish members like Eric Rosengren of the Boston Fed. This can't be a coincidence. There obviously was a concerted effort to communicate this message.
The market is still skeptical. Right now the fed funds futures market implies 30% odds that the Fed will hike in June and 51% odds that the Fed will hike in either June or July. We can forgive bond traders for being confused. The core data don't seem much different between the Fed's March/April meetings vs. now. The most recent job report showed mildly slower gains. The Core PCE price report was also a little slower. Neither were so bad that it would dissuade a rate hike if they were already so inclined. But by not hiking in March or April, I think most market participants assumed there needed to be some data acceleration in order to spur a hike. There hasn't been and yet the Fed seems to be talking up the possibilities.
There are two possible motivations for this. One might be that the Fed is just trying to create some uncertainty (they want the market to think that any meeting is in fact live and were disturbed by the fact that prior to Wednesday, the market had only priced in around 5% odds of a rate hike in June). So, they talk up how June could be a reasonable time to hike. If that is indeed their goal, then in some sense the mission has been accomplished. The market is pricing in just 30% odds of a hike right now, but if all the Fed wanted was for the market to have some doubt that June could be real, then the communication worked.
The problem with this is if they don't hike, then what? The Fed becomes the proverbial boy who cried wolf. In 2015, they told us midyear. But they didn't hike in midyear. Then they told us June. If they don't hike in June, are we going to believe them the next time they cry rate hike? Probably not.
So now they absolutely must hike in June. If they don't, their words will have no meaning and only actions will matter. That becomes a much more volatile world, where incoming data has very little effect on the market and actual Fed meetings have way too much impact. That isn't a very clean environment in which to execute monetary policy. The Fed was trying to tamp down volatility by being more transparent. That could have worked if they had followed through on their words. But now they are risking totally destroying the last vestiges of credibility they had. They have to hike in June.
This article is commentary by an independent contributor. At the time of publication, the author held no positions in the stocks mentioned.