The capital markets are starting to reflect the increasing belief that the Federal Reserve will punt on beginning to raise rates in June. The new consensus is that Chair Janet Yellen will begin walking back expectations of imminent rate hikes when she provides the semiannual monetary policy report to Congress later this month, which will be followed by official punting verbiage in the statement provided by the Federal Open Market Committee following the March 18 meeting.
Evidence of this new consensus is apparent in commentary from financial pundits across all asset classes. Markit Economics opened its commentary on January's Purchasing Managers Index (PMI) for the services this morning with: "January data pointed to sustained growth of business activity across the U.S. service sector, but the latest increase in incoming new work was the slowest since the survey began in October 2009."
As is always the case, the informational point of that line is what comes after the "but."
Last week, in an article in The Wall Street Journal, UBS financial adviser Alan Rechtschaffen was quoted as saying that the Fed could begin to lay the groundwork for a transition in monetary policy toward a later date for interest-rate increases.
Not as direct but more notable was a letter from the Federal Reserve Bank of San Francisco ("Persistent Overoptimism About Economic Growth) in which Fed staff economists Kevin Lansing and Benjamin Pyle blasted the FOMC and its members (their bosses) for being persistently wrong on projections of economic growth.
This is an extension of the observation that private-sector economists consistently overestimate the economic potential, which helped give rise to a series of "nowcasting" systems by Federal Reserve banks (I discussed this in "The Rise of 'Nowcasting' Economic Activity" last August).
The shift in consensus toward the belief that the Fed will soon announce its intentions to punt on rates is being reflected in the capital markets as the dollar index declines and oil and long-end Treasury yields rise. This is an immediate realignment of these markets to expectations of the Fed postponing rate hikes this year, and it should not be construed as anything else.
This shift in expectations for monetary policy and the realignment of the capital markets to it is distracting attention away from another associated issue, however. Monetary policy isn't working as intended.
One of the reasons the Fed has been focused on raising rates is because of concerns about the potential for cheap debt to be used to put on financial trades that could drive asset values across all classes, but most important drive equities above what real production can support -- commonly referred to as a bubble.
This has been a talking point of the St. Louis Federal Reserve President James Bullard. The point Bullard makes about low rates being the catalyst for bubbles in the financial system is accurate. Although he doesn't state it directly, he is expressing frustration with the largest banks and their largest non-bank customers for lending and borrowing for purposes other than for increasing production and real economic activity.
The monetary stimulus has allowed the largest banks and corporate borrowers to become giant government-sponsored hedge funds. Cheap debt capital supplied to the financial markets through the banks has caused the growth in carry trades used for financial purposes to increase at a faster-than-exponential rate. It's also reflected in the greater-than-exponential growth of commercial and industrial (C&I) loans that are being made by banks to their largest borrowers for purposes they were never intended for -- financial purposes rather than productive purposes.
The Fed is right to be concerned about this activity and is frustrated that it is happening. That's the message the FOMC members should be discussing publicly as a rationale for wanting to raise rates, instead of the nonsense concerning the unemployment rate dropping.
But there's a problem with that rationale too, and it reveals a structural issue within the monetary system. The Fed can be frustrated with what the banks and borrowers are using cheap capital (supplied by the monetary authorities) for. They can announce plans to raise rates for whatever reason they wish. They can warn about bubbles forming if rates don't rise.
In the end, none of this matters. The Fed is required to supply the reserves necessary for the U.S. banking system to meet requirements regardless of whether or not the loans being made by the banks that require the increase in reserves meet the growth objectives of the Fed.
Put another way: The banks make monetary policy, not the Fed.