Fed’s Signal Failure

In the wake of July’s Greek Debt Crisis and August’s alarming Chinese growth data, the global stock market is in a state of turmoil. Stock markets worldwide, including Stockholm’s OMXS and New York’s Dow Jones have seen wild intraday trading and this year’s gains of roughly 20 % have been completely erased. In unstable times such as these, investors turn to policy makers for clarity. However, Janet Yellen and Fed presidents made, by their latest statements, a decision to leave rates untouched, and rather adding to the common insecurity than removing it.

On “Black Monday”, september 24th 2015, global stock markets experienced their worst losses in years; the leading Chinese index Shanghai Composite dropped a whopping 8,49 % and sent the Dow Jones down by an unprecedented 1089 points at opening. Single-day losses have thankfully not yet amounted to the same levels in September, but trading remains choppy and highly sensitive to macro news from China, the latest being a six-year low in the China Caixin PMI.

However, in spite of the negative performance of its stock market, the US economy is still going strong. Growing at 3,9 %, and keeping unemployment at 5,1 %, fed boss Janet Yellen recently called it “impressive”. The normal course of action to prevent the economy from overheating would be a rate hike, however due to the US economy’s global importance Fed finds itself in a tricky situation as a hike could fuel further global pessimism. On the other hand, markets reacted negatively to the decision to not increase the interest rate, as a large portion of investors call for a firmer line of action and more guidance. A key part of Fed’s role in the financial system is just that, to signal future action and guide investors to price assets and adjust expectations accordingly.

All year, Yellen & Fed said a hike would come in 2015, strongly hinting September. Ultimately, Fed chose to make a 180-degree turn and leave rates unchanged. Critics claim that Fed is allowing itself to be governed by the market and not the opposite. While Fed naturally should be able to re-examine its position, it ought to convey consistent messages to the market, and in the days since the decision it has clearly failed to do so.

After announcing the unchanged rate, Fed presidents have publicly spoken out against the decision, clearly revealing a crack inside Fed. Yellen herself said that a hike is still likely to happen in 2015 though it was right not to raise rates, citing low commodity prices and stock market volatility as key reasons. Influential NY Fed president William Dudley stated the same. But what prevents the proponents of a hike to get cold feet again?

Due to this ambiguous communication, investors have been left to guess if and when the hike will come. What is worse, Fed is losing credibility claiming that a hike will still occur in 2015. If there is something Fed should fear, it is losing its signal effect and thus a potentially soothing effect on markets. Today’s policy makers are undoubtedly navigating some murky waters, but they cannot expect the crew to stay calm if they do not have route and make clear who is in charge.

“You Just Got Slapped “ might be a familiar phrase for fans of the American sitcom “How I met your mother”. In this case, however, it was not Marshall slapping Barney, but rather the invisible hand of the market slapping the Volkswagen management hard on both cheeks for deceiving shareholders and authorities alike. The scandal erupted when intelligence surfaced that German car manufacturing giant, Volkswagen, had deliberately manipulated nitrogen oxide emission tests for years through installing devices that hid the fact that emission levels grossly exceeded permitted levels. Subsequently, the news have garnered huge media attention, causing Volkswagen’s stock to plummet and the CEO to resign. Though many shareholders may have lost significant amounts of their investments, it shows that investors’ pursuit of profit actually can be good.

Adam Smith’s classical metaphor of how the invisible hand leads individuals pursuing personal wealth to collectively benefit society, has been taught in schools and universities for centuries. In its classical meaning, it highlights how the quest for profit increases the availability of goods in demand, decreases the price of them and facilitates the introduction of new technology.

From a stock market perspective though, the invisible hand works to “slap” i.e. punish firms that engage in unethical activities, in Volkswagen’s case fraud. What is particularly beneficial for society as a whole in the case of Volkswagen, is the familiarity of the brand. Since the German manufacturer is a globally renowned brand, the negative publicity caused by the scandal will reach all corners of the world. Hopefully, it will therefore serve as a future deterrent from manipulating tests and increase pressure on governments worldwide, to further increase the requirements of pollution emission.

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