[Janet Yellen ] The Federal Reserve wants to do two things right now: * Prepare markets for future interest rates hikes * Raise interest rates But the problem, according to Deutsche Bank's global economics team, is that by preparing markets for future interest rate hikes the Fed potentially hampers its ability to actually carry out those hikes in the future. Said another way, the Fed appears stuck in a negative feedback loop wherein suggestions that higher rates are coming create the unsettled conditions that ultimately force the Fed to keep rates right where they are. And so on. Deutsche Bank's latest note looks most closely at the Fed's relationship to financial conditions and whether a tightening of these conditions — basically, interest rates rising, credit issuance slowing — would prevent an interest rate hike. The short answer is maybe. But in my view the main takeaway from the report is that right now there are a number of tides the Fed is swimming upstream against, making its prospects for carrying out future rate hikes a potential challenge. Almost the least of which are how tight financial conditions either are or are not. [Screen Shot 2016 05 25 at 10.53.13 AM] Here's Deutsche Bank (emphasis added): The recent drumbeat of hawkish commentary from the Fed, along with last week’s release of the minutes from the April FOMC meeting, has triggered a sharp re-pricing of expectations for Fed rate hikes by the market. While the market was only pricing about 4% odds of a rate increase in June less than two weeks ago, those odds now stand close to one-third. IT IS BELIEVED THAT THIS SHIFT IN RHETORIC TOWARD A MORE HAWKISH MESSAGE WILL ULTIMATELY BE SELF-DEFEATING. By signaling rate hikes, interest rates adjust higher, the dollar strengthens, and risk assets may come under pressure. This produces tighter financial conditions, which ultimately prevent, or at least limit, the eventual rate increase. This natural tightening of financial conditions in response to rate hikes is expected. BUT THERE ARE REASONS TO BELIEVE THAT THIS NEGATIVE FEEDBACK LOOP MAY BE MORE SEVERE IN THE CURRENT ENVIRONMENT: A STRONGER DOLLAR IS LIKELY TO INCREASE PRESSURE ON CHINA’S CURRENCY AND WEIGH ON COMMODITY PRICES, THEREBY RE-INTRODUCING THE KEY ELEMENTS OF STRESS THAT LED TO A SHARP TIGHTENING OF FINANCIAL CONDITIONS EARLIER THIS YEAR. IF THIS VIEW IS CORRECT, THE SCOPE FOR FURTHER RATE INCREASES BY THE FED IS REDUCED. So again, by saying higher rates are coming the Fed creates a sort of chain reaction in financial markets that lead, among other things, to tighter financial conditions, a strong dollar pressuring commodity prices, and stock markets potentially getting rattled. This is the thinking that undergirds the idea that the Fed can never really raise interest rates. If you view the Fed's ultimate goal as raising interest rates from current levels, this is a problem. But if you view the Fed's posturing as merely that, well, none of this is really a surprise. In the end, Deutsche Bank's conclusion is really just mealy-mouthed economist speak (again, emphasis mine): The evolution of financial conditions will be critical for whether the Fed will be able to raise rates in the coming months. OUR ANALYSIS FINDS EVIDENCE THAT A NEGATIVE FEEDBACK LOOP DOES EXIST BETWEEN THE MARKET’S EXPECTATIONS FOR THE FED AND FINANCIAL CONDITIONS. HOWEVER, WE BELIEVE THAT, ABSENT A SHOCK FROM CHINA IN THE MONTHS AHEAD – WHICH IS CLEARLY DIFFICULT TO PREDICT – IT IS UNLIKELY THAT A NEGATIVE FEEDBACK LOOP THAT TIGHTENS FINANCIAL CONDITIONS WILL PREVENT THE FED FROM HIKING. Alternatively: here is a problem for the Fed, except right now it isn't a problem, unless it becomes a problem. So as tends to be the case with Fed-related forecasting, whatever you were already thinking can probably be justified. The next Fed meeting is June 15. SEE ALSO: THE FED COMES ROARING BACK TO LIFE Join the conversation about this story » NOW WATCH: FORMER GREEK FINANCE MINISTER: The single largest threat to the global economy
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