To Correctly Predict the Fed's Policy Path, Watch This

The Federal Reserve (Fed) left policy unchanged last week, continuing a “wait-and-see” approach appropriate for today’s global economic, financial and inflationary conditions.

So, with the Fed on the right track for now, you may be wondering: When will the central bank again start the process of rate normalization? Accurately judging the Fed’s policy path will require keeping an eye on two factors.

Domestic economic “warning signs”

In other words, watch corporate profits, jobs growth and inflation. Corporations in the S&P 500 Index are in the process of printing their sixth consecutive quarterly earnings decline. This has profound implications for forward growth potential in capital expenditures and hiring. In fact, I’ve long argued that we’re likely to see a weakening in employment growth in the second half of the year, as reduced earnings tend to translate into lower payrolls with a roughly six-month lag. If this does occur, the Fed may have difficultly hiking rates, especially if inflation remains weak. In that scenario, I would expect no more than one Fed policy rate hike this year, as labor market strength has been the highlight of recent economic performance.

Conditions abroad, and particularly in China

For clues to any Fed move, watch the U.S. dollar (USD), as a gauge of potential stress in the global financial system, and financial conditions in China. It would be misguided for the Fed to disregard international economic developments, risks, and financial conditions, as if the U.S. economy were completely immune to disruptions from outside its borders.

So, in addition to worrying about its traditional domestic considerations of labor market growth and inflation, the Fed is understandably concerned with risks from abroad. This is evident in the more dovish language coming from the Fed recently that clearly accounts for the importance of the dollar in the global framework, the stresses to international trade partners, as well as the challenges that China’s economy faces in its transition. See the chart below, examining the language in Fed Chair Janet Yellen’s economic outlook speeches.


Given the importance of China to the global growth dynamic, and the country’s previous effective peg to the USD, it’s not surprising that USD strengthening in 2014 and 2015 placed great pressure on China’s growth rate. Indeed, dollar strength has been a key fault line stressing financial markets in late-2015 and early-2016.

Global financial condition stress has eased in recent months due to a modest stabilization in the USD and continued aggressive policy response from foreign central banks. In addition, the recovery of commodity prices is indicative of stabilizing growth in China and much of the emerging world. Looking forward, Fed caution, along with other factors, is likely to keep the dollar fairly stable, or at least keep it from rising excessively. This would go some distance in keeping China and emerging market (EM) growth in a better place.

For now, these factors suggest that the Fed will remain on pause for the next few months at least, the pace of rate normalization will be slow and the central bank will probably be limited to one, or even no, hikes this year. In the meantime, correctly predicting when the next hike will take place will require paying close attention to global financial conditions along with domestic economic fault lines.

Rick Rieder, Managing Director, is BlackRock’s Chief Investment Officer of Global Fixed Income and is a regular contributor to The Blog.

This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of May 2016 and may change as subsequent conditions vary. The information and opinions contained in this post are derived from proprietary and nonproprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by BlackRock, its officers, employees or agents. This post may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections and forecasts. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this post is at the sole discretion of the reader.

Investing involves risks including possible loss of principal. Fixed income risks include interest-rate and credit risk. Typically, when interest rates rise, there is a corresponding decline in bond values. Credit risk refers to the possibility that the bond issuer will not be able to make principal and interest payments.

Carefully consider a Fund’s investment objectives, risk factors, and charges and expenses before investing. This and other information can be found in the Fund’s prospectus or, if available, the summary prospectus which may be obtained by visiting the BlackRock Fund prospectus pages. Read the prospectus carefully before investing.

©2016 BlackRock, Inc. All rights reserved. iSHARES and BLACKROCK are registered trademarks of BlackRock, Inc., or its subsidiaries. All other marks are the property of their respective owners.


© BlackRock

Read more commentaries by BlackRock