Strategy & economics
Fed sheds its interest rate reserve
So, after months of prevarication, the US Federal Reserve (the Fed) has finally made its move. For the first time since mid-2006, the financial markets have had to confront an increase in interest rates. Leading into the announcement on the 16th December, asset markets saw an appreciable increase in volatility. In part this was the direct consequence of the expected increase in rates for valuations. In addition, the prospective tightening caused investors to fret about the implications of tightening US policy on emerging economies, particularly commodity producers. These fears were exacerbated by the growing realisation that all is not well in the People’s Republic of China.
Now that the first move has been made, the policy debate, which had become stalled at the exact timing of the change, will move on. There will be four areas of debate: how quickly will rates rise, how high will they eventually rise, what will be the impact on the US and other economies, and what are the implications for monetary policy elsewhere. Encompassing all these, perhaps, there is a central question regarding the behaviour of the Fed and all other policy makers: how inflation tolerant will they prove if and when the current period of exceptionally low inflation comes to an end? The possibility that central banks might adopt a more benign policy stance towards rising inflation was also discussed in the immediate aftermath of the financial crisis – the issue being whether the objective of holding down inflation would always take precedence or whether there could be times when other macro-economic objectives might (or should) become the priority.
At the two extremes are those who believe that central banks will simply return to previously established policy objectives (for example, 2% inflation in the UK), and will not risk weakening the anchor on inflation expectations, and those who believe that policy makers will be forced to become more pragmatic and accept that tolerating a period of higher inflation is the only way of easing the debt burden on borrowers (whether they be individuals, companies or governments). Of course, there are many shades between the extremes. Central banks themselves, might argue in favour of adopting a more lenient approach towards future inflation if they were able to guarantee that after a period of, say, five years of 4% to 5% inflation, it would then be easy to bring the rate back to 2%. The danger would be that, in allowing inflation to drift higher, central banks would lose credibility. Rising expectations could then make it difficult to cap the rate of increase in prices at 5%, requiring tough policy action to bring inflation back down to a rate considered acceptable in the longer term.
At the same time, a greater tolerance of medium-term inflation could lead to greater swings in the underlying economic cycle. For these reasons, I doubt that Western central banks will attempt to inflate their way out of debt. More likely, they are likely to take the view that a prolonged period of dull growth is not just safer but will prove the most effective way of reducing debt-to-income ratios.
This does not, of course, help answer the questions relating to shorter-term policy issues. For the Fed, Bank of England and other central banks, policy decisions are likely to be strongly influenced by how current conditions are perceived. The necessity to justify rate increases by hard facts means that policy is likely to remain less forward looking. This will result in an increasing risk that eventually policy makers find themselves behind the curve – and that at some stage they are forced to run to catch up. But this problem, if it arises, is unlikely to become obvious before 2017.
While the Fed might continue to err on the side of caution when tightening, it seems highly improbable that they will have endorsed one change in rates without agreeing that further rate rises are likely to be necessary over the period ahead. My base case is that the Fed raises rates by 25bp each quarter. However, I would be the first to acknowledge that the risks around this assumption are skewed. While it is quite possible that rates will rise less quickly, it seems unlikely that the pace will be faster. Eventually, I would expect rates to rise towards the trend nominal growth rate in the economy – to around 4% – but this level might not be seen for a number of years and possibly not even in this policy cycle.
As to the economic impact, I believe this will be less than feared. Interest rates are so low that it seems unlikely that the first few increases will have a meaningful impact on credit creation. Indeed, we could even see a period of faster lending growth, as borrowers move to lock in a lower short-term rate structure. Nonetheless, there will be worry that a US tightening is having a stronger than anticipated impact on demand, not just in the US economy, but on others as well – particularly emerging economies. As a result, the first stages of policy normalisation are likely to be characterised by higher anxiety levels, with investors proving highly sensitive to adverse news on both growth and inflation. In this context, adverse news on growth refers to a pickup in momentum. So, we are now at the stage of the growth/policy cycle when good news on the former is bad news for the latter. For emerging economies, both manufacturers and commodity producers, this is a major conundrum. While they might benefit from stronger demand growth in the US and elsewhere in the West, they are likely to suffer financial stress if interest rates are raised as a result.
If you happen to be outside the US, you will be very focused on the implications of a tightening by the Fed for policy regimes in other areas. Policy linkages will be largely determined by where countries and areas are in their own growth cycles. The UK is at a similar stage as the US, and I believe there is a strong possibility that rates here will rise in the second quarter of 2016. Contrariwise, in the eurozone, the European Central Bank is unlikely to shift from its current course until 2017 – although if it were up to the German Bundesbank, that moment would almost certainly arrive considerably sooner.
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