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No Rate Change: Doves Hold Hawks at Bay


TOM BUTCHER: Natalia, was the Federal Reserve's (“Fed”) decision at its September 20-21 meeting to leave rates unchanged expected or unexpected?


NATALIA GURUSHINA: It was certainly expected given that the implied probability of a September hike was barely above 20%. But there were some noteworthy outcomes that accompanied the decision. First, there were three dissenting hawkish votes, and this number is unusually high. This is very interesting in that we now have three FOMC [Federal Open Market Committee] members who think that the policy rate should remain unchanged in 2016. What this tells us is that the Fed is increasingly split in its decision making.


Another interesting point is that even though the Fed's decision was in line with where the U.S. economy is in the current business cycle, the decision was yet again at odds with explanations that the Fed has provided, and also with its macro forecasts, which remained virtually unchanged in September. Nevertheless, the Fed pulled down the expected path of the policy rate and, importantly, the expected terminal policy rate is now below 3%. Remember, the rate was at 3.5% at the end of 2015.


Unfortunately, this ongoing downward revision of the terminal rate raises these questions: How confident is the Fed with its inflation target, and also with its estimate of the neutral policy rate? Both of these concerns, unfortunately, do not engender greater confidence in the Fed. With regards to the emerging markets assets reaction, I would say it is consistent with explanations provided by the Fed, but probably not as much with the fact that the U.S. economy continues to look weaker as would be implied by the Fed's forecast.


BUTCHER: Let’s look a little closer at how the Fed’s decision fits into the U.S. business cycle.


GURUSHINA: The Fed's decision has been described by some as a “hawkish hold”. This implies a fairly high probability of a December hike, and this is precisely what markets have currently priced in. We are in an interesting situation right now due to the consequences of multiple quantitative easings. The growth rate is low, inflation is low, interest rates are low, and money velocity is very low. But at the same time, it is very important to understand that the business cycle in the U.S. is alive and well, even though it might be very shallow this time around.


It is also important to place the discussion about the Fed in a context of the business cycle. We are seeing an increasing number of macroeconomic releases that signal that the U.S. economy might already be at the late stage of an expansion. Even for those areas of the economy where there has been tremendous improvement, there are a number of indicators which are, unfortunately, not moving in the right direction. Take, for example, the labor market. If you look at the overall rate of unemployment, it looks picture perfect. At the same time, however, the rate of under-employment is stuck at levels well above long-term historic averages. Also, non-farm payroll growth is decelerating, and the [United States] Labor Market Conditions Index is clearly topping off. If, indeed, the U.S. economy is already at the late stage of this recovery, then any additional tightening by the Fed under these circumstances should not be warranted. In the worst-case scenario, tightening might actually push the economy into recession. But, as I mentioned earlier, the Fed looks split in its decision making, and the large number of hawkish dissenters might be a consideration that we should take into account going forward.


BUTCHER: Would you expand more on the implications of the Fed’s decision for emerging markets?


GURUSHINA: I think that in the near term, there are definitely quite a few tailwinds for emerging markets as a result of the Fed’s decision. For example, a weaker U.S. dollar is usually associated with larger inflows to emerging markets. The Fed’s decision to hold rates should encourage more risk-taking by investors; it should also encourage emerging markets central banks to be less hawkish. Lower interest rates in emerging markets is a tailwind to growth, in part through leveraging, for example. But it is really difficult, however, to predict how long that tailwind is going to last, in part because of the uncertainty about aggregate demand in developed markets.


What we are seriously concerned about is a stagflation-type scenario in which growth in the U.S. decelerates, while inflation pressures go up. If the Fed chooses to hike rates going into such a scenario, then the implications for emerging markets will be much more problematic. Rolling over debt for both sovereigns and corporates would be more expensive. This would probably result in growth deceleration, capital outflows, and market corrections.


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Fixed income securities are subject to credit risk and interest rate risk. High yield bonds may be subject to greater risk of loss of income and principal and are likely to be more sensitive to adverse economic changes than higher rated securities. Bonds and bond funds will decrease in value as interest rates rise. Please note that, generally, unconstrained bond funds may have higher fees than core bond funds due to the specialized nature of their strategies. International investing involves additional risks, which include greater market volatility, the availability of less reliable financial information, higher transactional and custody costs, taxation by foreign governments, decreased market liquidity, and political instability. Changes in currency exchange rates may negatively impact an investment’s return. Investments in emerging markets securities are subject to elevated risks, which include, among others, expropriation, confiscatory taxation, issues with repatriation of investment income, limitations of foreign ownership, political instability, armed conflict, and social instability.


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