A new wave of economic optimism in both the US and UK, alongside the Federal Reserve’s recent decision to taper its programme of Quantitative Easing—scale back its asset purchases—opens a new chapter for monetary policy in both countries. After five years of unconventional monetary policies, investors have every right to think we have arrived at the beginning of the end. But they should also see this moment as the beginning of a trend towards higher interest rates. The two new central bank heads, Janet Yellen in the US and Mark Carney in Britain are facing a new quandary, and will have to manage carefully the markets’ propensity to discount higher interest rates, especially in view of extremely low levels of inflation. If they don’t do this well, the credibility of forward guidance could be seriously damaged, leading to renewed market and economic volatility.
The terms of forward guidance will have to be reformulated so that central banks won’t be ambushed by markets into premature increases in policy rates. Normally, low inflation is the result of earlier economic weakness and rises as the economy strengthens. But in today’s post-crisis world, excessively low inflation could be a leading rather than a lagging indicator, and be a cause of future economic weakness because low inflation raises the real value of debt and debt servicing. Against this background, premature monetary tightening would be an embarrassing own-goal.
Getting interest rates back to normal is, of course, a desirable goal in spite of negative effects on those with mortgages. It would help to correct many ‘distributional’ issues that have accumulated under QE. Savers, and retirement plans would benefit. Lower corporate pension plan sponsorship costs would help cashflows. The aggravation of income inequality, spurred by the effect of QE on asset prices, would be relieved. The restoration of a proper cost of capital would improve lending decisions, and induce companies to borrow for investment rather than buying their own stock back.
But despite the better economic news in the US and UK, things are not yet so robust that we can be glib about the return of higher interest rates. Yet this is precisely the risk that is looming for two reasons.
First, the single focus on unemployment thresholds is flawed. With US unemployment at 7 per cent, the Fed has already ‘coloured’ its 6.5 per cent threshold by saying that unemployment would have to fall ‘well…