Why Fed should have Chosen to be data dependent and why not anymore.

It’s good to be back writing something after a long while. Better late than never, they say  J.

The Fed’s delayed hike has been causing some stir in the markets recently. The markets expecting a rate hike in this year, were largely caught wrong footed by dovish Fed as the year draws to a close. Despite encouraging data –on average- the Fed’s caution draws a lot from mix of external as well as internal factors. The markets seem to have become self-aware,  causing a volatility in  betting on Fed’s first hike as the Fed remains muted and largely vague in their decision about selecting and conveying the.

What are the reasons behind it? There may be many, but my two cents say that Fed itself is responsible for this confusion among the markets.  How do I believe so? This goes back months when I was listening to the interview of a US Navy Pilot describing his aircraft “departing” or losing control and stalling. His reaction was,” If I’d try to fight the situation by increasing the throttle, I’d only had ended up making it worse. So I just put my hands in the lap and enjoyed the ride until the aircraft stabilized”. Similar was the case with most of the central banks when the emergence of  The Great Recession tested the policy innovation capacity of the central banks in developed world. From rate cuts to various forms of QE, every central bank did what it could do so i.e. take a shot in the dark and hope for a bullseye. It was largely because

1.       Central Banks didn’t completely know the extent of the crisis.

2.       And they couldn't fight the crisis with conventional wisdom.

So the just like a fireman not knowing which rooms are on fire, they took the safest bet i.e. covering the whole building with water cannons and rolled out very large QE programs. Equally important alongside firefighting was rescue job. The Central Banks were not only to fight the crisis but also tag markets along. And since the economy was like the plane of Naval aviator, they did what they could do best i.e. wait and see,

Resultantly, the central banks became data dependent in their outlook because

1.       It lent more transparency to central bank’s decision in the time of great uncertainty.

2.       It took the burden off the Central Banks and gave markets a benchmark for recovery.

The strategy worked well for good period of time as the recession retreated and recover started to take place. However, there was a key shortcoming in adopting this strategy i.e. data’s inability to be used as a policy tool e.g. Interest rates, Reserve Requirements etc. It’s just like a turkey hunter putting one’s gun on a random shooting machine. The shooter is indifferent in night as the both would aim almost equally effectively. But as the day approaches and hunter sees turkeys moving around, the random gun shooting machine spoils his chances of shooting more accurately by himself. Likewise, the policy of remaining data dependence may have worked exceptionally well during the days of the crisis but it may do more harm than good in the days when there’s a greater extent of certainty around.  In addition, this data paradigm is strictly engulfing the market thinking i.e. The data will drive the Central Bank. Result is a rapid plunge in rate hike expectations as soon as the two NFP numbers came below expectations.  Also, if Fed continues to hold onto this notion of being driven by data, then I don’t really see a good chance of rate hike before June 2016. I’d say so because the seasonality continues to affect the data during the winters and markets, believing that Central Bank would be driven by the data flow, would push the rate hike expectations further despite Central Bank seeing it as a appropriate time for policy normalization.

So in the end, I believe that it’s about time that  Fed

1.       Determines the appropriateness of remaining data dependent

And, if she feels so, to exercise more judgment about the outlook so that the uncertainty is reduced and markets have a clear view of when a rate hike would be more probable.

Note: Errors and Omissions are expected because I didn't get it proof read by someone.