It depends upon the result of the Presidential election—but we can make an educated guessby George Magnus / June 14, 2016 / Leave a comment
Today sees the start of a two-day meeting of the Federal Reserve’s policy-making committee, called the Federal Open Market Committee. Unlike the Bank of England, the European Central Bank or the Bank of Japan, the US’ central bank’s policy discussions nowadays are regularly about whether they should raise interest rates—and when might be a good time to do that. Although this is a mark of the American economy’s relatively successful performance since the financial crisis, the Fed is still in a tricky position, and keeps running into the economic equivalent of flak, sometimes thrown up by the US economy, and sometimes by foreign developments, notably in China and in the form of a strong US dollar.
Today’s meeting starts just over a week from the UK’s EU referendum, with widespread concerns, already evident in markets, that a “Leave” vote would precipitate financial instability. This week then the Fed is not expected to follow-up the rise in interest rates announced last December, the first hike since 2006. But higher US interest rates are still on the Fed’s agenda. As Sterling’s legs give way on the foreign exchange market before the referendum, we Brits should take note.
Some think the Fed is playing with fire in wanting to raise interest rates, and it is fair to point out that some of its best-laid plans have gone astray. In the spring of 2013, it announced plans to “taper,” or unwind, its quantitative easing programme of asset purchases. Financial markets in the US and around the world took fright, and the Fed had to back away until the end of the year, finally ending QE in October 2014. Twice last year, the Fed gave notice that it was inclined to raise interest rates but on both occasions, in the spring and again in September, it had to give in to domestic and Chinese economic worries, respectively. Finally, it raised the interest rate in December, but expectations of a follow-up in March were quickly dashed by the financial turbulence related to falling stock prices and to China at the start of the year, and then the expectation for June ran into an unexpectedly weak employment report for May, announced two weeks ago. The data meant that the average job gains in the last three months were half the pace recorded over the last 12 months.
The Fed’s task to normalise monetary policy has therefore not been straightforward. To a large extent, this is because the economy in the US, as elsewhere, is not the same as it was before the financial crisis. Population growth is slowing at the same time as the population is ageing, so increasingly there are fewer working-age people to support each retired citizen. This is lowering consumption growth, and ushering in less dynamic consumption patterns. Income and inter-generational inequality are restraining demand. Even if workers in continuous employment over the last few years are now getting wage rises of over three per cent, the average for all employees is sticky at a meagre 2.5 per cent. Households are saving: in the first quarter, the savings rate was variously estimated at between 5.7 and 9 per cent of income. Inflation remains quite subdued with the Fed’s preferred measure, the so-called personal consumption deflator excluding food and energy, still falling just short of the two per cent target, which hasn’t been met for four years.
Moreover, companies aren’t investing as much as they used to, for various reasons related to economic uncertainty, misaligned incentives, weaker earnings, and the capital conservation effects of new digital technologies. Yet, they have also taken on a significant amount of debt in recent years, not so much for investment as to finance buy-backs of common stock and dividend payments. For non-financial companies in the S&P 500 index, the ratio of debt to pre-tax earnings has recently increased, making them more vulnerable to both higher interest rates and weaker earnings from a slower economy.
Nevertheless, the Fed still thinks it is appropriate to steer cautiously towards a normalisation of interest rates. They prefer to call it a “reduction in monetary accommodation,” which is central bank speak for “we are removing excessive monetary ease, but not imposing a tight policy that will choke the economy.” Some of us think this is the right thing to do, and implicitly puts pressure on the US government to live up to a responsibility it has shunned, which is to use its own balance sheet to help the economy sustain spending and demand.
After all, the labour market is close to full employment. Labour force growth of just 80-100,000 jobs per month on average would sustain the status quo. The leading indicator of initial claims for unemployment insurance is at a 42 year low, and while there is plenty of room for labour force participation rates to recoup past losses, ageing and other factors may well mean these rates will remain permanently lower than in the past. In any event, the recent trend to lower job gains coupled with GDP that has probably risen back to 2-2.5 per cent after a softer winter means productivity growth must have recovered. This will protect firms’ weakening profit margins in the face of slow, but steady improvement in wage increases. Moreover, consumption spending in inflation-adjusted terms in April rose by three per cent compared to a year ago, and consumer balance sheets are relatively strong. Debt ratios have fallen, and the savings rate in the first quarter was variously estimated at between 5.7-9 per cent, depending on the choice of measurement.
The outlook for Fed policy on a month to month basis is a bit of a coin toss. But it certainly seems that the Fed, navigating a course that’s hostage to post-crisis headwinds on the home front, and external sources of instability, intends to nudge interest rates a little higher over the next six months and beyond. If the economy can sustain underlying growth of 2-2.5 per cent, the labour market remains firm, and wage increases edge up, it will probably raise interest rates once or twice this year and maybe two-three times in 2017.
But there is something the Fed cannot discount and that financial markets cannot price that may throw the balance between these arguments completely off-kilter: the coming presidential election. The uncertainty before November may well inject angst into financial markets and keep the Fed quiet closer to the event. Afterwards, the chasm in what to expect from a Trump, as opposed to a Clinton presidency, will have profound consequences for the economy and can hardly fail to influence the Fed.