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Is the U.S. Fed Sending Mixed Messages?

TOM BUTCHER: What can we learn from the latest Federal Open Market Committee meeting?

NATALIA GURUSHINA: One thing I find positive is the link between projections; the expected policy reports and the market’s forecast were a little bit more consistent this time. We have a revision of the expected policy path by about a 0.25 percentage point across the board, but we also have a lower growth forecast and a lower inflation forecast, so there was consistency there.

What was a bit disappointing is that the communication between the markets and the Fed did not really improve that much. The Fed's message remained fairly convoluted. On the one hand, the Fed invoked global factors and put special emphasis on global developments in its statement, and this probably includes some financial instability, for example, in China and lower emerging markets [EM] growth. All of this, however, takes place against a backdrop of improvements in the U.S. economy. Another interesting fact is the Fed mentioned inflation, lower inflation, and inflation expectations, specifically lower market-based inflation expectations. On the one hand, nobody can deny that the economy experienced a deflation shock in the summer but on the other hand, we see factors, such as labor market developments and growth in money aggregates that indicate that perhaps the global deflation shock is temporary.

Another interesting point is the Fed communication includes a reference to the need for further improvement in the U.S. labor market. What exactly does the Fed mean? Because the gap between NAIRU (non-accelerating inflation rate of unemployment) and the unemployment rate is virtually zero, we can only speculate that maybe the Fed is talking about part-timers, which indeed put downward pressure on wages, and as a result, downward pressure on inflation. However, this was not very clearly communicated. Also, there is unfortunately more evidence of disagreements among the FOMC members, and I think it is interesting that one of the members voted for additional policy accommodations through negative rates in 2015 and 2016. That was new and very interesting, and unfortunately didn't offer much certainty to market participants. 


The bottom line is there is no less uncertainty post-the-FOMC meeting, which suggests to me that market volatility and risk premiums might not decline unless communication improves.

BUTCHER: Can you tell me about the market's expectations and, in particular, what investors should look out for?

GURUSHINA: There was a big change in market expectations after the FOMC meeting, in the sense that markets are not pricing in anything for this year. The implied probability of a move in October is around 20% right now, and it's below 50% for December. Market expectations regarding the time of the Fed liftoff moved from about three months from now to five-and-a-half months within a few days. The markets are not pricing in any move by the Fed between now and the end of the year. What we need to watch are two groups of factors. On the global side, EM growth and developments in China are key. Commodity prices are also very important. Internally, I think we need to watch any changes in inflation expectations, both by professional forecasters and also by the markets. Incidentally, market expectations went up only a bit in the past couple of weeks. Another factor to watch is developments in the labor market, since the Fed made reference to the need for further improvements. I think the part-timers, the ratio, and the further decline in that ratio should be monitored very closely.

BUTCHER: Finally, can you provide your Q4 outlook for emerging markets debt?

GURUSHINA: I think the fact that the Fed is more dovish now is definitely more bullish for duration. In that sense I think we can talk about import. With respect to EM FX [emerging markets foreign exchange], I think the picture is more complicated because the Fed invoked global developments in its statement. That includes EM growth. If the Fed is concerned about global developments, and it says that the growth outlook in emerging markets may not be as strong as it previously thought, then the outlook for EM FX probably is a bit more selective than uniform. Our preference is to express a more positive and more bullish view on duration in a select number of countries as regards to EM FX.

BUTCHER: Natalia, thank you very much for joining me today.


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