With the US Federal Reserve apparently concerned that they might be forced to react too quickly if the economy starts “getting overly frothy,” a Deutsche Bank report looks at increasingly hawkish comments by Fed speakers and thinks Fed Chair Janet Yellen is not likely to stoke fear in Jackson Hole. The report points to a consistent pattern of Fed speak that points to a new rate hike rational: market stability.

DB 8 22 us real model

Deutsche Bank doesn’t expect Fed Chair Yellen to say much in Jackson Hole

Dominic Konstam and his Deutsche Bank team writing the August 19 US Fixed Income Weekly report note “misgivings on the Fed.”

“Some Fed officials appear to be making another attempt at jaw boning market expectations for Fed hikes a little higher – at least into the September meeting,” they write, pointing to New York Federal Reserve Bank President William Dudley and San Francisco Fed President John Williams. Last week ValueWalk reported on an expected increase in Fed hawkish comments.

The report, written before Fed Vice Chair Stanley Fischer noted the US central bank is close to hitting its job and inflation targets, is expected to be in contrast to a more muted Fed Chair Janet Yellen in Jackson Hole. The Deutsche Bank analysts think Yellen will generally hold her tongue at the event that is not her favorite for policy pronouncements.

“It will be important for the current market equilibrium that she doesn’t stoke any smoldering ash” in her comments, the report said. “On that basis we are still inclined to fade Fed hike expectations and favor lower nominal yields led by much lower real yields.”

The report said the increasing grumblings that point to a September rate hike are potentially misguided and that “normalizing” rates might not happen next month.

DB 8 22 rates

Deutsche Bank notes Fed thinking has moved from “low for long” to “data dependent” and is more concerned about financial stability

What is happening regarding Fed intentions on interest rates is an evolution of a thought process.

First there was a Fed “precommitment to keeping rates low for long,” which helped calm jittery markets. Then the Fed said that it was becoming “data dependent” and would consider rate hikes as the economic numbers provided glimpses of strength.

We have now moved into a new Fed thought processes, the report says.

“It would appear now that there is a more subtle evolution in the process – with more members thinking beyond data dependence and looking at financial stability concerns.

“There has been a steady drumbeat of increasing focus on financial stability issues,” the report noted. “Specifically the last two meetings have ‘several’ members willing to push on with gradual rate increases due to concerns for financial stability as the data dependent concerns subside.”

DB 8 22 inflation

Note the consistency in communication that documents the Fed trend and points to raising rates in a controlled fashion rather than being forced to make quick and rash moves

The Duetsche Bank report notes the same issues A Bank of America Merrill Lynch research piece did and points to a trend in Fed speak on the topic of stability.

In March, for instance, the FOMC Minutes noted stability concerns when they said: “Increasing the target range for the federal funds rate too gradually in the near term risked having to raise it quickly later, which could cause economic and financial strains at that time.”

Then go to the April FOMC minutes, where the Fed once again expressed concern about raising interest rates too quickly: “…large and persistent deviations of the federal funds rate from these benchmarks, in their view, posed a risk that the removal of policy accommodation was proceeding too slowly and that the Committee might, in the future, find it necessary to raise the federal funds rate quickly to combat inflation pressures, potentially unduly disrupting economic or financial activity.”

But the trend becomes more apparent when the June Fed minutes are examined: “Several of these participants expressed concern that a delay in resuming further gradual increases in the federal funds rate would increase the risks to financial stability…” But the concerns with quick forced rate rises was confirmed in other sentences that noted the “rapid removal of policy accommodation at some point in the future … could entail significant risks for U.S. financial markets and the economy.”

And then the trend is once again apparent in July, the most recent of the FOMC minutes being perhaps the most clear yet: “[S]everal expressed concern that an extended period of low interest rates risked intensifying incentives for investors to reach for yield and could lead to the mis-allocation of capital and mispricing of risk, with possible adverse consequences for financial stability.”

This consistent drum beat of Fed voices points to a central bank that wants to raise rates in a gradual, controlled fashion so as not to surprise markets or create negative volatility. “The concern, as reflected in the July minutes, might be that by delaying too long, long rates will be too low for too long and this may create misallocations of investor capital and expose asset prices to undesirable price corrections at a later stage, presumably when the Fed catches up on rate hikes,” Deutsche Bank said. “Since the Fed directly recognizes the link between financial stability and its own macroeconomic mandate, the concern is that in this event they would effectively be hampering their ability to sustain full employment and reach their inflation objective.”