The shadow of the financial crash is finally being cast offby George Magnus / December 14, 2015 / Leave a comment
On Tuesday and Wednesday this week, the Federal Reserve will hold its last meeting of the year. And announce its first hike for 10 years. There are at least three reasons for the heightened state of anticipation surrounding it, especially the angst about whether it will amount to a policy error. All things considered, it’s the right thing to do, probably.
First, unless something shocking should happen, it will announce a change in interest rates for the first time since the financial crisis and the arrival of ZIRP or zero interest rate policy, and a rise for the first time since 2006. It came close to this decision at its meeting in September, but backed off in the face of the global market disturbances arising from turbulent developments in China’s equity market and the strange case of the mini-devaluation of the Yuan.
Second, the Fed is out there all on its own, aside from some emerging market central banks, for example in South America and Sub-Sahara Africa, still raising interest rates to help stabilise their currencies against a resurgent US dollar. Importantly, the European Central Bank and the Bank of Japan are leaning in precisely the opposite direction as far as monetary policy is concerned, and the Bank of England is on hold for the foreseeable future.
Third, a lot of people are worried the Fed is about to commit a major error. Even though central banks don’t raise interest rates once in the belief that a one-off will suffice, many commentators and economists think the Fed may find out as soon as early next year that it will have to freeze further increases or even reverse what it has done by then. It is certainly likely that the first rise in rates is less important than the expectations built into the markets about how far the Fed will raise rates and over what period of time. At the moment, markets expect rates to rise by little more than 0.5% by the end of 2016. They could be wrong of course, but the US and the global economy should be able to withstand this sort of reduced accommodation —a superior phrase to “tightening”—possibly a little more.
I imagine the Fed’s policy-makers are well aware of the risk and have no intention of following in the footsteps of the 15 OECD central banks that have raised interest rates since 2011 only to reverse the increase(s) subsequently, and in some cases, take interest rates down to lower levels than where they began. That said, there is little question that in what are still extraordinary economic circumstances nowadays, the Fed is about to embark on an extraordinary journey.
Normally, the Fed—any central bank in fact—tightens monetary policy in the face of rising inflation (relative to its target), itself usually a manifestation of vigorous or accelerating demand growth, buoyant wage formation and rising corporate profits, and what we nerdily call narrowing credit spreads, aka rising appetite among investors to take risk by buying below investment-grade financial products. To coin a phrase, the Fed’s role in such circumstances is to “take away the punch bowl” and calm things down.
In today’s US economy, none of these circumstances exist. The Fed’s preferred inflation indicator, the so-called personal consumption deflator is less than 0.5% higher than a year ago, and the core rate, excluding food and energy, is about 1.4% higher and has been trending sideways all year. The latest slide in oil prices will further delay the technical rise in inflation expected in the new year. Wages are stirring a little, but at best, at a very early stage; aggregate corporate profits are flat or down compared to 2014; and spreads are rising, that is risk appetite is falling.
Even though “normal” circumstances don’t apply, judged by the last decades, it is also true that the emergency conditions that necessitated exceptional monetary policies and zero rates as the financial crisis and recession erupted are also no longer present. The case for starting to reduce the amount of monetary accommodation checks other important boxes, including as part of the toolkit to quell speculation and future financial instability, and as a message to lawmakers that monetary policy shouldn’t be the only “game in town.”
Most people’s favourite place for an accident is the vast US corporate bond market, to which companies with low credit ratings have flocked this year in particular. Last week two mutual funds specialising in this type of instrument had to shut down in the face of losses and redemptions and investors. One of them, Third Avenue, was the third largest mutual fund to close since 2008. Others expect emerging markets, already hemorrhaging capital outflows, to reel again, as highly indebted non-financial companies balk under the pressure from higher US dollar financing costs.
While these risks are real enough, investors should be allowed to take losses. And for emerging markets, currently in a growth hiatus of unknown duration, and with many suffering from commodity price drops and home-made policy failings, the Fed’s early and cautious policy moves are not their biggest sources of concern. They will rue a rise in US interest rates much less than appreciate the relative firmness of the US economy that has brought the Fed to this point.
The US economy will be the be all and end all of the Fed’s decision, and the arbiter of whether it was right or wrong to hike in December. In spite of reservations about the strength of the labour market and the about the fall in the participation rate especially, 5% unemployment an the early signs of rising wages and salaries are something the Fed can cite as rationale. Technically, inflation readings should pick up a bit by next spring. Capital investment by companies has been on a rising trend, although companies do report, temporarily one imagines, relatively high levels of inventories.
The Fed can’t do anything about the major effect of lower oil prices on energy investment plans. Its policies though do affect the value of the US dollar which has a bearing on manufacturing in general, and exports in particular. Slightly higher interest rates shouldn’t affect mortgage costs too much, given the preponderance of fixed rate financing, but might affect automobile and other consumer loan programmes. The Fed’s policy judgement will probably be that on balance, it’s the right time to start the process of putting some blue water between the financial crisis and the present.
We shall have to scrutinise closely the Fed’s actions, the language of its decision-making, and the way in which the economy responds over the next few months. The only thing we can say with some confidence, as things stand today, is that the Fed won’t be able to give itself enough monetary policy ammunition to cut rates aggressively next time the economy lapses into a recession. But… you have to start somewhere.