Interest rates: How high? How fast? And why?
Whether you sit on the hawkish or dovish side of the fence, one thing is clear: Interest rates globally are on the rise. But how far, how fast, and with inflation virtually absent worldwide, why?
Whether you sit on the hawkish or dovish side of the fence, one thing is clear: Interest rates globally are on the rise. But how far, how fast, and with inflation virtually absent worldwide, why?
Whether you sit on the hawkish or dovish side of the fence, one thing is clear: Interest rates globally are on the rise. But how far, how fast, and with inflation virtually absent worldwide, why?
As usual, global financial markets are taking their lead from the US Federal Reserve. From their first hike this cycle in December 2014, rates have now risen four times. And as the December Federal Open Market Committee (FOMC) meeting draws ever nearer, markets are now belatedly accepting that rates will rise a fifth time taking the range to 1.25%-1.50%.
Other central banks globally are falling in behind the Fed. The Bank of Canada has now raised rates twice for a total of 0.5% taking policy rates there to 1.0%. They will probably follow through with another hike in early 2018. Even in Brexit-beleaguered Britain, the Bank of England are preparing markets for a reversal of the emergency cut they implemented after the vote to leave the EU. And the European Central Bank (ECB), arguably the world’s most dovish central bank, are even now preparing markets for the beginning of the end of their quantitative easing programme.
Central Bankers don’t like the suggestion that they aren’t independent. It makes it much harder to justify their large salaries and generous pensions. But as interest rate differentials are still the major determinant of exchange rates, and exchange rates still one of the major determinants of growth and inflation, it is no surprise to see their herd-like behaviour.
Asian central banks have managed to resist being drawn into the same pattern so far, with a few (Bank Indonesia, Reserve Bank of India) even finding room for some easing. But this is only because the dollar has been so weak for much of the year, insulating Asian economies from any imported inflation and buying them some time. But even in Asia, the ultimate direction for rates is the same, eventually.
Markets have, for the most part, been pretty relaxed about what the Fed was doing. Each rate hike has been approached almost as if it were the last, with little further tightening priced in until it has actually taken place. Longer term interest rates have risen a little, but are still very subdued, suggesting that the market remains unconvinced about the need for further tightening. Stock markets, which usually react negatively to rate rises, have shrugged off each hike, continuing instead to make new record highs.
Happy days, but not that surprising when you add up all the money printed by major central banks in recent decades. Give or take the odd trillion, this adds up to about $10 trillion. That money has to go somewhere…
But not everyone is happy. Even within the Fed’s rate-setting committee, there are strident voices against even the cautious rate increases that Fed Chair Janet Yellen has overseen. The big problem for them, it seems, is that the business cycle isn’t working as it normally does.
In a stylistic diagram of the business cycle, economic growth or employment drifts slowly up and down, with inflation trailing it in the same direction, but with a lag of several years. Aside from a couple of quarters of contraction caused by extreme weather (and likely poor seasonal adjustment) the US recovery has now been ongoing for 8 years since growth troughed out in mid-2009. By historical standards, this is already a pretty long upswing. Yet the inflation that is meant to follow in its wake is mysteriously absent, with the Fed’s preferred measure only 1.4% (August PCE). This isn’t supposed to happen.
For the doves, most of whom will have grown up on a diet of “Philipp’s curves” and a history of inflation running well above 2%, the absence of higher inflation screams “leave rates alone”, or even “reverse the tightening”.
But Yellen, who is widely regarded as a dove, keeps tightening. So, has she lost the plot? And is she, like previous generations of central bankers, going to whip the punch-bowl from the market revellers before the party has even really got started? We think not.
There are three principal reasons for this.
1) Inflation is badly measured, and there is no one “correct rate”
2) The relationship between growth and inflation may have broken down
3) Inflation is the target, but not the ultimate goal
If you work with economic data as part of your job, you soon realize how flaky much of it is. The Fed likes the PCE inflation measure. But that runs consistently below the CPI measure. Which one is right? Probably neither. In short, when aiming for a 2% target, anything within about half a percent of the target should be regarded as a “hit” – economist-style. The Fed’s preferred measure of inflation won’t likely be close to your or my own personal inflation rate, or that of your neighbour two doors down the road.
Such spurious scientific accuracy by the dismal scientists in charge of rate setting is really unhelpful. And why 2%, not 3% or 1%? Measuring inflation to two decimal places as some economies do in Asia do, is simply mindboggling.
The second factor is interesting, whether true or not, because practically all macroeconomics models across the planet have at their heart, a growth or employment trade-off with inflation. But as our third point asks, is controlling inflation even really the job of a central bank? Or is it just a convenient yardstick for ensuring that monetary policy settings are about right?
Putting it another way, if the speedometer of your car breaks, does that mean you should slam down the accelerator because the needle suggests you are stationary? And is the speed limit always the same in all circumstances? The answers are pretty obviously no in each case. The real goal is to safely and efficiently proceed from A to B, as indeed it is with the economy.
So, far from risking a market crash with their behaviour, the Fed, and Bank of Canada and maybe even the ECB in time are ensuring the party goes on a little longer, though perhaps at the expense of watering down the party punch in the meantime.
Few people claim they can predict asset price bubbles before they burst. But that does not excuse deliberately stoking them. As central banks realized after the Global Financial Crisis, the available tools for mopping up the ensuing mess were virtually useless. Some caution is definitely warranted. And right now, there are countless examples of markets that might or might not be bubbles: residential property, high yield, EM (emerging market) debt. This is the equivalent of watching the scenery from your car window flash by in a blur. Forget what the speedometer is showing, it’s time to step gently on the brakes.
Of course, there are other points of view, one of which is that inflation is structurally lower. That means that the long run risk-free rate of government bond yields, from which all asset valuations are based, will also be lower. Overvalued stocks? Nonsense, according to this view.
But do any of you remember the so-called new paradigm? Equity analysts churned out reports suggesting that negative profits were irrelevant. What you really needed to know about the stock was the click-rate, or some other new-fangled metric. That was the real nonsense. And this structural story sounds very much like yet another ex-post rationalisation for woolly thinking and recklessly loose policy setting.
So where does this all end? With any luck, nowhere near the long-run estimate of rates suggested by the Fed’s now infamous dot-diagram. We strongly doubt Yellen is going to be nearly as aggressive as that. That means there is a good chance that markets can at least maintain current levels, or even inch higher. That $10trn of printed money is going nowhere fast, and every dip will look like a buying opportunity to the portfolio managers, even if the motivation for fresh buying is beginning to look more and more jaded.
Sooner or later, there will be another market crash. That is about the only inevitability of financial markets. And when it happens, someone will be blamed. Whoever is running the Fed at that time stands a good chance of taking the flak, whether it is Yellen or someone else. But if whoever is running the Fed next year carries on cautiously tightening as Yellen has been doing, then they raise the probability that this is pushed far enough out to be someone else’s problem.