Why Data, Not Lipreading, Hold Key to Liftoff

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You'd be forgiven for feeling that the Fed's being fickle. Two weeks ago, the Federal Open Market Committee seemed pretty dovish. Not only did it keep rates static, but we learned two clear reasons why: low inflation and conditions outside the US.

Indeed, in her press conference following the FOMC's latest announcement, Fed Chair Janet Yellen specifically cited China's economic and financial volatility as reasons for staying the course, noting the need to carefully watch the interconnectedness between international conditions and the US economy.

Not surprisingly, the stock market reacted negatively to her words and started tumbling down the wall of worry. That is, until late last week, when Yellen seemed to have adopted a more hawkish—and, to the markets, a much more welcome—tone.

In a very lengthy speech, Yellen stated her belief that inflation will meet the FOMC's target in the next few years—and argued that the factors suppressing inflation today are largely transitory in nature. Although she provided the caveat that "economists' understanding of the dynamics of inflation is far from perfect," she reiterated her belief that the Fed will raise rates in 2015.

As expected, that speech elicited a positive reaction among stock investors. However, that reaction was surprising for two reasons. First, the US is continuing to struggle with realizing higher inflation due to a variety of downward pressures on prices. Second, investors heard news last week about new signs of global economic weakness: China's manufacturing PMI clocked in at its lowest level since 2009, and Brazil's central bank forecast that its economy will contract by 2.7% this year.

Several weeks ago, we suggested that the cacophony of voices and opinions from different FOMC members is creating enormous confusion and conflicting expectations about when rates will finally lift off. We argued that in this environment, investors should pay attention to data rather than words.

This is, admittedly, easier said than done, but it's critical: If we start listening to frequently conflicting Fed voices, rather than just examining the data, then we could start losing confidence. Even though the Fed risks not acting this year, we have to believe that it will stay true to its words and that data will dictate its actions. Given that credibility is in short supply in Washington D.C., this is more important than ever.

After all, we have something else to worry about as we head into autumn: another possible government shutdown. While our experts place the odds of a shutdown at well below 50%, particularly after House of Representatives Speaker John Boehner's resignation, it remains a possibility. Remember what the last government shutdown did to investor confidence? At that time, the Fed became the fourth—and most reliable—branch of government. What would happen this year if the legislative and executive branches lose credibility at the same time the Fed is also suffering from a credibility deficit? The volatility we've seen since August could become exacerbated.

In summary, we should expect that the normalization of monetary policy after such incredible and extraordinary accommodation is not going to be easy, and it will involve many moving parts. So as we await September's jobs report on Friday, we should expect every piece of new data to take on increased importance.

Yet while we should be focusing on the data, we can't let any single data point dictate our actions, since the Fed is looking at a broad mosaic of metrics. For investors with short-term time horizons, protecting positions and managing volatility is critical. For those with longer-term plans, it's important to stay well-diversified while maintaining exposure to risk assets.

Kristina Hooper is the US Investment Strategist and Head of US Capital Markets Research & Strategy for Allianz Global Investors. She has a B.A. from Wellesley College, a J.D. from Pace Law, a master's degree in labor economics from Cornell University and an M.B.A. in finance from NYU, where she was a teaching fellow in macroeconomics.

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