The Shortest Tightening Cycle Ever

To be sure, this is a strange title for a blog when you consider that the Federal Reserve hasn’t even started to raise interest rates yet.

Nevertheless, given the Fed posturing and signaling over the last few months, and the employment report that came out today, the Fed is all set to tighten policy for the first time in a decade. My expectation is that it will raise the federal funds rate by 25 basis points in December—and then go out of its way to explain to the world that it will remain “data-dependent” and gradual in its approach to policy tightening after its initial rate hike.

I have no reason to doubt the Fed’s intentions on that front. I firmly believe that the ruling majority in the Federal Open Market Committee is still concerned about the fragile state of the global economy. Nevertheless, it will likely vote on tightening policy because the employment picture in the United States has improved. In the Fed’s judgment, it is better to raise rates now in order to slow things down, rather than to clamp down if inflation were to accelerate later. The Fed’s base case is that the U.S. economy will continue to grow at the new trend rate of 2%, and inflation will slowly begin to inch back. This projection also happens to be the market’s goldilocks base case.

The Decision to Tighten in December Could Be Misguided

I understand the Fed’s logic but also firmly believe it is misplaced.

In my view, the world economy is still quite fragile, as some previous growth drivers are fading rapidly. Economic growth in emerging markets is decelerating. Developed markets are undergoing economic revival in aggregate, but at the end of the day, the U.S. economy is the only bright spot in that group. The Fed is poised to tighten policy. And the tightening of financial and credit conditions that has resulted from a stronger U.S. dollar and modestly wider credit spreads, will likely slow down the U.S. economy and kill the growth momentum of its services sector, which is the primary engine of growth left in the United States.

Therefore, I strongly believe that by the middle of next year, the upcoming tightening cycle that will likely begin this month will prove to be a policy mistake and, as a result, may be one of the shortest and shallowest tightening cycles in history. I believe the Fed will then reverse course in the not-too-distant future as quite a number of central banks in developed markets have done in the past.

Even if my prediction doesn’t prove to be the base case, I would assign an equal probability to this scenario as I would to the base case of a goldilocks scenario in which a Fed tightening is gradual and the U.S. economy continues to grow at its new trend rate of 2%, with inflation getting closer to the target.

With that being said, I think there is also a possibility—not large, but also not trivial—that the Fed is behind the curve and my views are misplaced. In that case, the Fed’s dot plots provide the path for Fed tightening beyond what the market expects, which is more in line with the Fed’s goldilocks hopes. I think this scenario is less probable but likely to prove very problematic for the markets.

The bottom line, in my view, is that the Fed is likely to raise rates in December. This is a regime change and, though markets and asset prices will be able to handle this regime change, I expect 2016 to see modest returns with much higher volatility than we have experienced in any year since the financial crisis of 2008-2009.

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