Why a Fed rate hike is not so scary
Effect on emerging market equities and currencies could vary
Effect on emerging markets equities and currencies could vary
The US and the world economy has come a long way from the “taper tantrum” of 2013, when Ben Bernanke, then the Fed chairman, announced the intention to climb down on quantitative easing.
Eventually, the tapering did happen, enough warnings have been issued since then that a “normalisation” of rates is on the cards and now it is almost certain that the Federal Reserve will increase the rates by 25 basis points this week. It would be the first time the Federal Open Market Committee (FOMC) — the Fed’s rate-setting team — has lifted its benchmark rate since 2006, beginning the socalled return to normal.
As for US rate hikes — the Fed has been preparing markets for more than two years for its first interest rate rise in nearly nine years. Interest rates close to 0 per cent and three rounds of quantitative easing were the Fed’s measures to deal with an extraordinary situation: the slow healing after the global financial crisis.
Now, with the US job market stabilising the Fed believes it should move to normalise interest rates. Last Friday’s US employment report was solid. Nonfarm payrolls increased by 211,000, above market consensus expectations of 200,000, while the October nonfarm payrolls were revised upwards to 298,000. The unemployment rate held steady at 5 per cent. Average hourly earnings increased 0.2 per cent compared to last month.
“These are all good signs that the labour market recovery has been getting stronger in the fourth quarter after a dip in the third. Two solid labour market reports in October and November strengthen the Federal Reserve’s case to go ahead with the first rate hike in two weeks. We expect this rate hike to be the one and only within the next year, as inflation prospects remain lousy and currently do not justify higher rates fundamentally,” said Christian Gattiker, Chief Strategist and Headof Research at Julius Baer.
Many economists argue that there is no urgency for the Fed to hike the rates at the moment. Though unemployment has fallen, the participation rate in the US labour market is at the lowest level since 1977. Second, inflation is below the Fed’s inflation target of 2 per cent. Third, the inflation pressure appears to be low, with wages well under control.
Japan
“The Fed seems eager to move, but also wants to make it clear that the hiking cycle will be very gradual. The risk with this approach, as Japan discovered in 2000 when it hiked prematurely, is that the Fed might find it hard to convince markets of its intended gradual pace,” said Marios Maratheftis, Chief Economist of Standard Chartered. “We think interest rates will peak at just 1 per cent by June 2016 and stay there for a prolonged period. Our forecasts are lower than market consensus and Fed projections,” he said.
Economists, market analysts and policymakers have been debating the far reaching consequences of a rate hike for more than two years. With just a few days to for the first tranche in a series of hikes expected from the Fed over the next several quarters, they say the impact of higher interest rates on economies, markets, companies and individuals will depend on their respective financial health and preparedness.
Whether you save, borrow, travel, want to buy a house or invest in stocks, a rate hike will almost certainly affect you in one way or another. Weaker financial market conditions combined with an increased sensitivity to US rates may heighten the risk of negative spillovers to emerging economies when US policy is normalised.
On the one hand, a solid US recovery, the basis for an interest rate hike, is likely to benefit emerging economies through trade channels. On the other hand, further dollar appreciation and increasing yields may pose additional risks to growth and inflation in some countries. Clearly, the transmission channels are going to be trade, capital flows and exchange rates.
While capital is expected move in the direction of appreciating dollar and dollar denominated assets from emerging markets, their asset prices and currencies are set to decline further as weakening current accounts and forex reserves apply increase downward pressure on emerging market currencies.
Thus, the problem for emerging economies isn’t just higher rates, it is the stronger dollar.
According to the economist Kevin O’Rourke, who has been doing a running comparison between the Great Depression that began in 1929 and the Great Recession that began almost eight years ago, the world has just passed a sad landmark.
While the initial slump this time around wasn’t nearly as bad as the collapse from 1929 to 1933, the recovery has been much weaker — and at this point world industrial production is doing worse than it did at the same point in the 1930s. A remarkable achievement!
But the bad news is unevenly distributed. In particular, Europe has done very badly, while America has done relatively well. True, US performance looks good only if you grade on a curve.
Still, unemployment has been cut in half, and the Federal Reserve is getting ready to raise interest rates at a time when its counterpart, the European Central Bank, is still desperately seeking ways to boost spending.
Now I believe that the Fed is making a mistake. But the fact that hiking rates is even halfway defensible is a sign that the US economy isn’t doing too badly. So what did we do right? The answer, basically, is that the Fed and the White House have mostly worried about the right things. (Congress, not so much.) Their actions fell far short of what should have been done; unemployment should have come down much faster than it did. But at least they avoided taking destructive steps to fight phantoms.
Start with the Fed. In his recent book The Courage to Act, Ben Bernanke, the former Fed chairman, celebrates his institution’s willingness to step in and rescue the financial system, which was indeed the right thing to do. But everyone did that.
The real profile in courage was the Fed’s behaviour in 2010-11, when it stood fast in the face of demands that it tighten policy despite high unemployment. The pressure was intense, with leading Republicans including Paul Ryan, now the speaker of the House, accusing Bernanke of “debasing” the dollar and suggesting that he was corruptly aiding President Barack Obama.
Hard-money advocates seized on a rise in headline consumer prices, claiming that it was a harbinger of high inflation to come. But the Fed stuck to its, um, printing presses, arguing that the rise in inflation was a one-time blip driven mainly by oil prices — and it was proved right.
Meanwhile, on the other side of the Atlantic, the European Central Bank gave in to inflation panic, raising interest rates twice in 2011 — and in so doing helped push the euro area into a double-dip recession.
What about the White House? Some of us warned from the beginning that the 2009 stimulus was too small and would fade out too fast, a warning vindicated by events. But it was much better than nothing, and was enacted over scorched-earth opposition from Republicans claiming that it would cause soaring interest rates and a fiscal crisis.
Again, this is in strong contrast to Europe, which never did much stimulus and turned quickly to savage austerity in debtor nations. Unfortunately, the US ended up doing a fair bit of austerity too, partly driven by conservative state governments, partly imposed by Republicans in Congress via blackmail over the federal debt ceiling. But the Obama administration at least tried to limit the damage.
Not-so-bad economy
The result of these not-so-bad policies is today’s not-so-bad economy. It’s not a great economy, by any measure: Unemployment is low, but that has a lot to do with a decline in the fraction of the population looking for work, and the weakness of wages ensures that it doesn’t feel like prosperity. Still, things could be worse.
And they may indeed get worse, which is why the Fed’s likely rate hike will be a mistake.
Fed officials believe that the solid job growth of the past couple of years — which happened, by the way, as Obamacare, which conservatives assured us would be a job killer, went into full effect — will continue even if rates go up. I’m among those who believe that America is facing growing drag from the weakness of other economies, especially because a rising dollar is making US manufacturing less competitive.
But those officials could be right, in which case waiting to raise rates could mean some acceleration of inflation.
On the other hand, they could be wrong, in which case a rate hike could end the run of good economic news. And this would be much more serious than a modest uptick in inflation, because it’s not at all clear what the Fed could do to fix its mistake.
I’m not sure why this argument, which a number of economists are making, isn’t getting much traction at the Fed. I suspect, however, that officials have been worn down by incessant criticism of their policies, and want to throw the critics a bone.
But those critics have been wrong every step of the way. Why start taking them seriously now?