It is what happens after the Fed rate hike that matters more

Godot is about to arrive. Charlie Brown will kick the football. This week, the Federal Reserve will raise interest rates.

That at least now appears overwhelmingly likely. Anything else would be the biggest shock of a year in which markets and monetary authorities have had a number of serious misunderstandings. Let us assume for now that it happens.

This will be the longest-awaited and most-previewed tightening of monetary policy in history. Both the financial media and brokers’ research departments have spent years telling you that this moment is really important.

Maybe I am jaded after years of speculating about something that does not happen, but here are some reasons why a Fed rate rise does not, in fact, matter that much:

The dollar:

Central banks dislike admitting it, but foreign exchange moves matter to them. The stronger dollar, by making imports cheaper and exports more expensive, has pushed down on inflation and tightened the economy this year, doing much of the Fed’s work for it.

The Fed matters greatly to the dollar, of course. But so do other factors. The mere prospect of a divergence in monetary policy this year has been enough to force up the dollar 11 per cent against other currencies. And while expectations for the Fed remained constant, the market disappointment that the European Central Bank did not do more to ease monetary policy last week saw that suddenly unwind; the dollar at one point lost 4.6 per cent against the euro, in a move that effectively eased policy.

Forex markets overshoot. Other central banks are determined to ease. If the dollar moves well above parity with the euro, or if an emerging currency spiralled lower, such events could swamp anything the Fed does.

The world is less reliant on oil than it was in the 1970s. But the oil price still matters. A lower oil price spells problems for oil producers (like Russia), and helps oil importers (led by India). For the Fed, cheaper oil reduces inflation but also reduces capital expenditures and heightens risks of defaults, with consequent financial system disruption, among the companies that sprang up to exploit the boom in fracking.

Last week ended with Mario Draghi claiming he could expand the ECB’s balance sheet without limit, and with Opec’s news that it would not try to limit supply. Stocks fell across the world; oil affects them more than central banks.

The Fed has to control inflation and promote full employment, so it cares about the labour market. Arguments about whether stronger employment numbers would really push up inflation (a relationship long assumed to be true and known as the Phillips Curve), have dominated the Fed’s debate this year.

Opec:

The US labour market:

We know about the rate rise. What we don’t know is the course of rises thereafter, which is far more important. The markets currently think that rise will be very gentle, and the Fed will probably signal as much. The most plausible factor that could speed them up would be wage inflation.

Higher wage costs

This is not the base case. But the latest survey of small business owners finds the rate of companies finding it hard to fill positions higher than it was in 2006 and 2007. Average hourly earnings have ticked up in the employment data, while restaurant chains and retailers have revealed tighter margins due to higher wage costs. Watch the labour market — it could yet produce an ugly surprise.

The world economy is now bipolar with growth concentrated in its second-biggest economy, China. The People’s Bank of China is undeniably far less predictable than the Fed.

Indeed the biggest shock of 2015 — which helped scare the Fed away from hiking rates in September — came when the Chinese authorities allowed the yuan to devalue without briefing the markets in advance.

Further devaluation would ease China’s attempt to make the transition away from an export-led manufacturing economy.

But by making Chinese goods even cheaper it would export deflation and

China:

make it harder for many emerging markets to compete. If Chinese growth were to sputter out into a true crash, then the effect on commodity prices the world over would be drastic — far more impactful than anything the Fed could do.

Note well, then, that the yuan is now weaker than it was ever allowed to close during August, and that JPMorgan’s basket of 11 emerging currencies (which does not include China’s yuan), has just dropped to an all-time low, falling below its trough from September. That could forcibly redraw many assumptions.

The Fed is increasingly viewed as a political vehicle within the US, with a sizeable faction within the Republican party now objecting to its very existence.

This is a recent development, however. Each of the last three Fed chairmen — Paul Volcker, Alan Greenspan and Ben Bernanke — were appointed or reappointed by both Republican and Democratic presidents.

In the unlikely but conceivable event that Americans elect a president dedicated to returning the US to the gold standard or to abolishing the Fed, the effects would be far reaching. More broadly, electorates around the world are angry, for good reason, and in the mood to do things that capital markets, and central bankers, will dislike.

The forces of democracy could yet drown out anything Janet Yellen says.

Politics: