That’s the question everyone is asking these days. Will the Fed go ahead and raise interest rates at their next meeting? Or is the economy still so soft they don’t dare derail what recovery we’ve managed to attain? Was last week’s employment report good enough to keep the Fed on track to do what they seem to think they need to do? A better question might be why they think they need to raise rates. Another good question would be how they intend to raise rates (not as easy to answer as you might think). A much better question would be why they think they know better than the market what interest rates should be.

The stock market had another bad week, down almost 3.5% and it is even money whether it is China or the Fed the market is most worried about. There’s a contingent that believes the turmoil in China and the other emerging markets is the source of angst in the US market. China’s slowing economy will drag down global growth and pinch corporate earnings. Another contingent believes the market is fretting about the impending rate hike and the potential for a Fed mistake, another form of the slowing growth fear, this time centered on the US. I’m part of a third contingent that says divining the motivations of millions of individuals is impossible – even for the Central Committee.

The common theme of the two explanations for the recent selloff is reduced growth expectations. Whether those falling growth expectations are a result of what is going on in China or at the Fed is essentially irrelevant. In fact, in many ways, the two are related, opposite sides of the global monetary policy coin. China’s biggest problem right now is capital flight, a recurring problem for emerging markets at the mercy of Fed policy. And at least part of that capital flight is being driven by the diverging monetary policies of the Fed and the PBOC.

China now finds itself in a tough spot. Capital outflows pressure the Yuan lower so they sell dollars and buy Yuan. But buying Yuan is a contraction of the domestic money supply and seen as detrimental to growth which accelerates the capital outflows. They have to take some other easing measure domestically – say reducing reserve requirements for banks – to offset the contractionary policy of defending the Yuan. It’s a Rube Goldberg way to run an economy, a Dr. Doolittle monetary policy of pushmi-pullyu that just looks confused to an outsider. (Note to those like Thomas Friedman who pined for the economic control of the Chinese government a few years ago: pulling the levers and pushing the buttons of a modern economy isn’t as easy as you or the Chinese imagine. This isn’t news to a lot of us. Please read Hayek’s Nobel acceptance speech.)

The Chinese policy of defending the Yuan at these levels creates strains in the US too. As China uses its reserves to defend its currency it has to sell US Treasuries, putting upward pressure on interest rates here in the US. In fact, any emerging market trying to defend its currency (admittedly not a lot of those right now) must do the same. As I’ve said before, in an era where expectations play such a large role in monetary policy, mere anticipation of a policy move is tantamount to enacting the policy change. So, anticipation of a Fed policy change creates an incentive to shift capital from China to the US, raising interest rates in the US and mitigating the need for the rate hike everyone is anticipating.

Which brings me back to my much better question of why the Fed believes it knows better than the market what interest rates should be. There is a lot of information embedded in market prices and the Fed, rather than trying to manipulate the market, would be wiser to just observe and react. If the Fed wants to create higher nominal growth – higher inflation and/or higher real growth – it should enact a policy that it believes will accomplish that goal. If the policy is successful it will be reflected in the markets. Bond yields will rise to reflect the expected higher nominal growth. TIPS will tell the Fed and other market participants whether the policy is creating an acceptable combination of inflation and real growth.

The Fed, as it often does, has correlation/causation confusion. Higher interest rates, rising interest rates, are positively correlated with higher nominal growth. But that doesn’t mean that higher interest rates caused more rapid nominal growth. Just because the Fed tries to force short term rates to look like their policy is working doesn’t mean it is or that the rest of the market will agree. Remember Alan Greenspan’s conundrum? Interest rates are a market signal, not a policy tool. And right now, despite the Chinese reserve selling, bond yields (longer term where the Fed and PBOC have less influence) are doing what they’ve been doing pretty steadily for the last 18 months – falling.

It isn’t only the bond markets that provide useful information about monetary policy. Commodity markets are also very sensitive to changes or expected changes in monetary policy. Regardless of how it is accomplished the market is fairly screaming right now that tightening policy is a bad idea. It isn’t just oil prices that are falling (and that isn’t just about fracking either), but rather almost all commodity prices. The CRB index is down 37% since mid-2014 and 15% in just the last few months. Gold is down almost 20% since 2014 and 9% since mid-May.

In fact, markets aren’t just saying that tightening policy is a bad idea; they are saying that policy is tight now and getting tighter. That’s what falling interest rates and a rising dollar – falling commodity prices – mean. If monetary policy was sufficiently loose those things would be going in the opposite direction. If it was neutral, then theoretically these indicators would be more stable as well. Certainly we wouldn’t be seeing double digit declines in commodity prices.

Monetary policy is about as confusing today as it has ever been. Are commodity prices falling because the market is anticipating tighter policy? Or because policy is already too tight? The bond markets say that inflation expectations are falling and real growth expectations are weak but fairly steady. Could looser policy get us more real growth or it would it just mean more inflation? Does the Fed care or are they just intent on hiking so they have room to cut when the next recession arrives? Will that desire create the very recession for which they want to reserve ammunition? Credit spreads continue to widen and stocks are falling, reflecting a reduced appetite for risk. Will increased risk aversion itself cause the conditions that investors fear? Does fear of recession create the market conditions that make recession more likely?

The Fed ought to ignore the calls for rate hikes or rate cuts or QE or whatever and concentrate on stabilizing the dollar as best they can. If they did that, interest rates would be a better reflection of actual conditions rather than a reflection of Fed desires and wishes. Will the Fed hike rates at the September meeting? I’m on record as saying I don’t expect a hike this year and I’ll stand by that but who the heck knows what they’ll do? And that is the real culprit in the recent market turmoil – uncertainty. It is emanating from China where policy appears contradictory. And it is in the daily speeches of the Fed open mouth committee. About the only thing investors are sure of is that they are unsure about the actions and the consequences of the PBOC and the Fed. Until that uncertainty is relieved, expect the volatility to continue.

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For information on Alhambra Investment Partners’ money management services and global portfolio approach to capital preservation, Joe Calhoun can be reached at: jyc3@4kb.d43.myftpupload.com or  305-233-3772. You can also book an appointment using our contact form.