Fed Returning America To Normality? It’s Just The Start

So, the Federal Reserve finally did it. I half-suspected Janet Yellen would find yet another excuse not to raise interest rates last week. But the Chair of the world’s most important central bank made her move, with the Fed’s Open Market Committee coming to a unanimous decision.

For the first time in almost a decade, US policymakers put up the “Fed Funds rate”. Having been steadily cut from late 2007, as the ghastly sub-prime crisis loomed into view, then dramatically slashed to historic lows after the Lehman Brothers collapse a year later, America’s benchmark price of money has sat at 0-0.25pc for an incredible seven years.

Last Thursday, this target band was raised to 0.25-0.5pc. While only a tiny technical increase, US authorities and policymakers worldwide view it as hugely symbolic, and hope it will mark a decisive break with the past.

Since December 2008, as America fought to avoid a wholesale banking collapse, then tried to stage a convincing economic recovery, US monetary policy has remained locked in crisis-management mode. There have been several false dawns, as America’s GDP numbers have shown promise for a quarter or two, leading to official talk of policy “normalization”, only for growth to slump back.

Then, in mid-2013, the mere suggestion of an imminent reduction in bond purchases by the Federal Reserve, funded by virtually printed money of course, was enough to cause a global sell-off. Government bonds – from America to Germany to Japan – got hammered in a so-called “taper tantrum”, as yields sky-rocketed just at the thought of America coming off the monetary steroids.

Last spring, too, even though US “quantitative easing” had by then been paused, we saw further volatility on global markets – again, spreading from America, across Europe and to the emerging markets – as the Fed floated the idea that rates could soon rise, the years of easy money possibly coming to an end.

The US authorities tried yet again over the summer, building up market expectations of a rate rise in September. Once more, though, the Fed retreated – pointing this time to a dip in the Chinese stock market, despite the market’s relatively small size.

Even now, numerous Western financial analysts are sucking their pencils, gripping and re-gripping their stress balls, given that the market for so-called “junk bonds” – high-yielding corporate debt – has lately hit the skids. Made up mostly of smaller firms, particularly in the oil and gas sector, volatility on this market hit a five-year high prior to the Fed’s announcement last week, not least as low oil prices continued to rock America’s upstart shale energy producers.

Given the extent to which such outfits have borrowed not just to get started, but to keep going as the Opec exporters’ cartel has driven down crude in a bid to protect market share, smart people are now view energy junk bonds as “the next sub-prime”. Despite such carnage on a bellwether market, one with a history of sparking wider systemic problems, Yellen and Co hiked rates last week anyway – mindful that delaying yet again risked unnerving markets even more.

The impact of this Fed rate rise on global stocks and bonds, together with the future path of US borrowing costs, is probably the most important economic question not just of 2016 but the rest of this decade. America has taken its first tentative steps away from an unprecedented economic experiment. When the Fed began its emergency QE programme in November 2008, it was billed as a $600bn exercise. The US central bank has, in fact, since expanded its balance sheet by $4,200bn – from 5pc to no less than 25pc of GDP in just 7 years. On top of that, rates have been nailed to the floor.

So, while the market reaction to the Fed’s heavily sign-posted action last week has so far been benign, don’t for a minute think that we’re back in the “world of normal”. While I’d love to agree with the raft of commentary telling of a new post-crisis era and pointing to the sunlit economic uplands, I fear that would be somewhat premature.

The Fed has raised rates to 0.5pc. US inflation, meanwhile, is 0.5pc. In real terms, then, rates in America are now precisely zero. America’s monetary policy has just gone from being astonishingly loose to ever so slightly less astonishingly loose. And, given that Western financial markets have been pumped up by years of printed money, sporting high valuations that belie broader economic weakness, why did the Fed feel able to pause QE (while not ruling its return) and now finally venture a tiny rate rise? Because the money-printing baton has been taken up not just by the Japanese but also the Europeans.

The Bank of Japan is in the midst of expanding its balance sheet from 40pc to no less than 70pc of GDP over three years. When trying to convey how historically unusual it is for an advanced economy, the world’s third-biggest, to be conducting such a crackpot policy, I run out of superlatives. The Eurozone, meanwhile, is now 9 months into a €1,100bn QE programme, as the eurocrats attempt to solve structural imbalances, to say nothing of the single currency’s inherent contradictions, by hosing down the region with printed money.

Would the Fed have dared to put its own QE on hold, and would it now be raising rates, if large central banks elsewhere weren’t still pumping out liquidity like billy-o, doing their bit to placate global markets? I think not.

For all the predictability of Yellen’s statement last week, the Fed’s move has served only to highlight on-going differences in the views of central bankers and investors. Such differences, if they’re sustained, tend to result in volatility, sharp corrections and damaging economic fall-out. Trying to instill confidence, Fed officials insisted last Wednesday that strong US growth will allow rates to rise “gradually but steadily” over the coming year, to a median forecast of 1.375pc by the end of 2016 – pointing to 3 or even 4 more quarter-point increases next year.

The Fed fund futures market tells a rather different story, with the weight of money pointing to a 0.835 implied target rate, suggesting on-going economic weakness and market nervousness will limit the Fed over the coming year, for all its efforts to signal the crisis is over, to perhaps just one more quarter point rise.

What most Telegraph readers want to know, in the here and now, is the extent to which Yellen’s move will affect thinking at the Bank of England – given that UK base rates have been down at 0.5pc since March 2009. While this increase by the Fed makes a move by the Bank more likely, the markets are still pricing the first UK rate rise for the start of 2017.

Britain and the US are expanding at similar rates – 2.3pc and 2.2pc respectively year-on-year – and have almost identical rates of unemployment (around 5pc). Having said that, UK fiscal policy is tighter and our pay growth remains subdued (not least due to high immigration) – both of which makes a rate rise less likely. Credit trends here, also, are far less expansionary than in the US – which, again, suggest there will be less pressure on the Bank immediate to follow the Fed.

The only certainty, though, is further uncertainty. UK rates could be forced up sooner, particularly if our still enormous external deficit weighs down on sterling and oil bounces back, causing inflation to spike.

This Fed move has been billed as a return to normality. It’s just the start, though, with a long way to go.


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