Yellen.  Yellen.  Yellen.  This is basically what Thursday[1] comes down to.  She is either going to have a strong opinion, or she is not.  We don’t know because she has not made a public appearance in a while.  My best guess is that she will err on the side of caution for the following reasons:

  • 150914 Market vs YellenShe has been dovish this year. The statements and minutes this year have generally been more dovish than the markets have expected.  The table on the right shows the dates of the FOMC statements and minutes in 2015, and the change in EDM7 on that day.[2]  The markets generally encapsulate all available information prior to the meetings/minutes.  However, the actual result has a noticeable dovish bias, as seen from the generally bullish market reaction afterwards.  We have rallied whopping 58bps total on those 10 days, with the three down days being negligible.  Since Jan 27 (the day before the first meeting of the year), EDM7 has only rallied 37.5bps, so 155% of the rally in EDM7 has occurred on those 10 Fed days.  While the rhetoric we hear from the FOMC members during the year is on balance more hawkish (thanks to the Bank Presidents speaking more often than the Governors), I can only conclude from the fact that the statement/minutes have been more dovish that Yellen has steered the discussion in a dovish direction.  Hitting 5.1 may be a turning point for an economic modeler like Yellen, but it seems unlikely that this of all times would be the time for her to flip to the Dark Side.
  • She relies on the Fed Staff to present the information. These are her people – if she didn’t find them useful to the Board, they probably wouldn’t be there.  The meeting is going to start with the Staff assessments. At the July meeting, their assessments of both the growth and inflation outlooks were to the downside.  I would be incredulous if either of those outlooks changed to “neutral,” given all the information we have gotten since the July meeting.  I would find it almost as incredulous if the Fed hiked with downside risks to both growth and inflation.
  • She believes in optimal control. I’m no optimal control expert, but it stresses growth over inflation.  It is not clear to me what happens to optimal control when the UR gets closer to “target.”  However, the argument could be made that there is still some slack in the labor market (especially with the target expected to be revised down).  And we still have no signs of inflation.  If anything, we probably have more downside risks than upside risks to inflation (and growth).
  • She believes in risk management. Is the error from hiking greater than the error from the status quo?  What exactly is the “risk” of staying put?  Isn’t some inflation in the world welcome right now?  I just don’t see why you would rush.  You can’t make the “get it over with while you have the chance” argument when the markets aren’t pricing it in.  I’m starting to think that it may be beneficial for the Fed to signal when liftoff will be – just to give the markets some clarity in jittery markets.  I know this goes against the anti-“measured” philosophy, but maybe they should make an exception just for liftoff.
  • Yellen is collegial. The IMF, World Bank, China, Summers, and a host of other notables have all urged the Fed not to hike for many reasons.  I know of NO ONE impartial[3] and relevant asking for a hike.  I have a hard time believing that collegial Yellen is going to completely ignore the arguments from respected peers.


So to summarize:

  • Probability that Fed “should” hike = 0%.  5.1% is an interesting data point, but not enough in my opinion to overcome all the other obstacles.
  • Probability that Fed “will” hike = 15%. It’s really hard to say what will happen at the meeting.  No one seems to have a strong opinion.  You expect the uber hawks to come out strong, but again, this will depend on Yellen’s mindset.  I nudged up the probability from 10% previously because Fischer did sound more neutral than I would have thought.  But this may have just been posturing.  The markets have 5.5bps priced in to October FF.  This seems high, but it’s not a screaming trade.

[1] Note it is not the “typical” Wednesday.

[2] It would be more accurate to take the pricing as of the data release, but this is a close enough proxy.

[3] I am not counting countries that would benefit from a stronger dollar, or people who are just talking their book.