Twenty-Five Basis Points That Could Shake the World

Never has so much been said by so many about so little.

The topic of this year's Jackson Hole symposium, sponsored by the Federal Reserve Bank of Kansas City, was "Inflation Dynamics and Monetary Policy." What made headlines instead were the yeas and nays from central bankers on the question of whether the Fed should begin the process of normalizing interest rates in September. The anticipated 25 basis point move may seem small in size but, as it turns out, is hardly small in scope. 

Some former nays - most notably Fed Vice Chairman Stanley Fischer - seemed more inclined to raise rates than he did three weeks ago, well before the stock market mayhem. New York Fed President Bill Dudley, on the other hand, said a rate hike was "less compelling" in light of market developments. His comments just happened to coincide with the turnaround in U.S. stock prices last Wednesday.

That the Fed is contemplating raising interest rates when central banks in the Euro zone, Japan, China and Canada are leaning in the opposite direction only adds to the potential impact. The U.S. dollar index has already appreciated 17 percent in the past year, making U.S. exports more expensive. 

Some Fed officials said they wanted to evaluate incoming data before committing to any decision on rates. What new information in the next two weeks could possibly be instrumental in that decision? 

"We now await the result of the August employment survey," Fischer said on Saturday.

Really? Friday's employment report for August, if it adheres to trend, should show some 200,000 new jobs created, an unemployment rate of 5.2 percent or 5.3 percent, a multi-decade low in the labor force participation rate and year-over-year wage growth of some 2 percent. What exactly would another month of status-quo employment statistics do to convince the Fed to act? And if the report is an  outlier in any way, then what? Wait for more data?

Perhaps policy makers want assurance that inflation is returning to its 2 percent target. Last week, we learned that inflation, as measured by the personal consumption expenditures price index, rose 0.3 percent in July from a year ago, within 0.1 percentage point of a six-year low. Excluding food and energy, the core PCE price index rose 1.3 percent year-over-year, the smallest increase since April 2011. Yes, inflation is a lagging indicator, but market-based indicators of inflation expectations have been falling. The spread between nominal and inflation-indexed 5-year Treasury notes has declined a full percentage point to 1.1 percent in the last three years. By the Fed's own estimates, inflation is not expected to hit 2 percent until 2017, which, if realized, would represent an undershoot for five years running.

The Fed keeps waiting for the "transitory effects" of last year's decline in oil prices to wash out of year-over-year inflation calculations. Crude oil's three-day rally notwithstanding, the renewed decline in commodity prices is apt to delay that transitory wash-out a bit longer.

In his presentation on Saturday, Fischer said the Fed is "interested more in where the U.S. economy is heading than in knowing whence it has come."

If he means what he says, the August employment report isn't going to offer much help. Either the Fed is a prisoner of the latest economic statistic, or the meltdown in China's stock market - with its ripple effect across the globe and implications for global growth - intruded on its best laid plans. 

The benchmark rate has been close to zero for almost seven years. What is the urgency to act now? Looking at the metrics the Fed cares about - economic growth, inflation, inflation expectations, wages, employment and financial stability - there is nothing screaming for a rate increase. In fact, were the benchmark rate not near zero, the idea of raising rates would not be on the Fed's agenda. 

Besides, markets are telling the Fed to wait. A rising dollar, falling commodity prices, declining long-term Treasury yields and widening credit spreads are not exactly symptoms of overly easy policy. And for all the Fed's incessant talk and minute-by-minute forward guidance, the fed funds futures markets have never been on board. The probability of a rate increase later this month is only 28 percent, according to the Chicago Mercantile Exchange's FedWatch tool. 

If I were a Fed official, I would give greater weight to the markets' consensus forecast than to the predictions of an econometric model. And the Fed should remember that with policy actions, as in life, timing is everything.