Is US central bank boss Janet Yellen already shying away from a December rate hike?
Investors were understandably confused by the mixed message contained in the minutes of the US Federal Reserve's September meeting, which were released overnight after the usual three-week lag.
On the surface, the Fed minutes appeared to suggest that September's decision to keep US official interest rates on hold was a "close call", and that the US central bank was just marking time until the November 8 US presidential election is out of the way.
"It was noted that a reasonable argument could be made either for an increase at this meeting or for waiting for some additional information on the labour market and inflation", the minutes said.
What's more, they appeared to be laying the groundwork for a December rate hike, with the minutes noting that some Fed officials believed it would be appropriate to raise short-term interest rates "relatively soon" if the labour market continued to improve and economic activity strengthened, while others wanted to see stronger evidence that inflation was moving closer to the 2 per cent target.
But investors – long used to the US central bank's extreme cautiousness when it comes to raising US interest rates – were quick to detect signs of equivocation in the official record of the Fed's last policy meeting.
Doves' arguments
They were encouraged to see that latest Fed minutes devote considerable space to the arguments advanced by the "doves" who believe the Fed should not feel any pressure to raise rates.
The doves argue that even though the US labour market is technically close to full employment – the US unemployment rate is 5 per cent – there is still significant slack due to the large number of disaffected people who quit the workforce because they couldn't find jobs.
According to the minutes, Fed officials discussed the "potential benefits and costs" of pushing the unemployment rate below the long-term normal rate, and that "many" of them "expressed the view that recent evidence suggested that some slack remained in the labour market".
The minutes also outline the dovish argument that, with interest rates so close to zero, it is riskier to raise rates prematurely than to keep them too low for too long.
"A couple of members emphasised that a cautious approach to removing accommodation was warranted given the proximity of policy rates to the effective lower bound, as the [Fed] had more scope to increase policy rates, if necessary, than to reduce them", the minutes said.
Signs that Yellen may be tilting more towards the dovish camp triggered a slight relief rally in the US bond market overnight. The yield on US 10-year bonds – which had climbed above 1.8 per cent before the release of the Fed minutes – eased back to 1.77 per cent (yields fall as bond prices rise).
But perhaps the biggest relief for markets is the Fed's signal in the minutes that it is keeping a vigilant watch for any threat to the US economic recovery.
Confidence shaken
At their September meeting, most Fed officials appeared sanguine that near-term economic risks – particularly from Brexit – had receded.
But their confidence will be shaken by the latest plunge in the pound, which this week fell to its lowest level on record according to the Bank of England trade-weighted index. The pound's effective exchange rate – which is measured against the currencies of Britain's major trading partners – hit a low of 73.38 on Tuesday, according to the BoE's daily measure. This is lower than levels hit during the financial crisis and even during the turmoil surrounding Britain's ejection from the European Rate Mechanism.
The pound has been under pressure since June when Britain voted to quit the European Union. But the decline accelerated last week, after British Prime Minister Theresa May signalled that her government was leaning towards a "hard" Brexit: one in which Britain would prioritise immigration over access to the EU's common market.
The pound's plunge is particularly unnerving for Fed officials, because it is taking place at a time when Beijing has allowed the yuan to fall to a six-year low.
The steep fall in these two major currencies will once again dampen US inflationary pressures by pushing down the price of imported goods.
And this will further strengthen the hand of the Fed doves who were already arguing at the September policy meeting that there were few signs of any inflationary pressures and that progress towards reaching the Fed's 2 per cent target had been slow.
