“I am not going to offer the incoming president advice about how to conduct himself”. So said Federal Reserve boss Janet Yellen last week, as the US central bank raised interest rates for only the second time in a decade.
The rate increase, in and of itself, wasn’t surprising. For months, various members of the Fed’s policy-making board have been publicly stating that higher rates were in the works. Still, despite the “quarter point” hike from 0.5pc to 0.75pc being “baked into” asset prices ahead of Wednesday’s announcement, the market reaction has been quite volatile.
And even though Trump won’t be inaugurated until January 20th, there are growing signs of a fundamental policy rift between the incoming President and the Chair of the Federal Reserve, despite her diplomatic language and pointed determination not to rise to reporters’ leading questions about the increasingly restless use of Twitter by “The Donald”.
Back in December 2015, the Fed raised its key interest rate for the first time in almost ten years. Having kept rates ultra-low since the 2008 financial crisis, policymakers indicated US monetary policy would “normalize” in the shape of three or four more rate increases during the course of 2016. That was never going to happen, as this column said at the time. And now, with 2016 about to end, the Fed has been able to just about manage one additional rate rise.
Numerous reasons have been put forward for the Fed not implementing the rate increases signalled this time last year. From “concerns about Chinese growth” to “terrorist threats” – and “Brexit” of course – US officialdom has come up with a range of excuses for keeping the monetary policy dials at emergency settings.
The genuine reasons, though, are obvious. The American economy has remained surprisingly weak for much of 2016. Having expanded 2.7pc in 2013, US growth slowed to 2.5pc the following year and 1.9pc in 2015. Growth has remained lacklustre for much of this year too, amidst weak manufacturing and house-building and fragile consumer spending. With the economy sluggish, the Fed has been reluctant to raise rates further.
The main reason policymakers have hesitated, though, is that with financial markets addicted to rock-bottom rates and ultra-loose money, a string of rate rises would have risked sparking an almighty crash. Now, extremely cautiously, after preparing the ground with a series of speeches by senior officials – and, crucially, with the European Central Bank, Bank of Japan and our very own Bank of England still churning out the QE funny market, keeping global markets on drip-feed – the Fed has dared to raise rates, by the smallest margin, to 0.75pc.
The reality is, of course, that with core inflation around 2pc, US interest rates remain negative in real terms. Monetary policy can in no way be described as “tight” after this increase. More accurately, policy is now “slightly less ultra-loose” than before. Recent data, meanwhile, suggest the US economy is gaining some traction, with surveys indicating stronger growth and consumer confidence. Unemployment is at a nine-year low of 4.6pc and headline inflation is up.
In truth, for all the Fed’s scientific chart-gazing and ponderous chin-stroking, it had nowhere else to go. To not have raised rates at all this year, having said it would deliver multiple-hikes during 2016, and with the numbers showing the economy clearly no longer on life-support, would have snuffed-out what remains of the US central bank’s already seriously depleted credibility.
Despite flagging-up this rate rise weeks in advance, the Fed’s move still led to investors dumping government bonds. Yields on shorter-dated US Treasury bills hit their highest levels in more than five years. The sell-off rippled across the globe, with European and Asian bonds also suffering.
The reason this happened is that the Fed is now publicly predicting it will implement a 0.25pc rate raise three times during 2017, rather than twice as it signalled back in September. That suggests the Fed expects higher inflation – which explains why bond yields rose, with investors demanding a higher rate to lend the US government money. Even though Yellen described this forecast alteration as “a very modest adjustment”, while stressing it reflects “the confidence we have in the progress the economy has made”, financial markets still took umbrage. The bond market rout continues at the time of writing – amidst loud predictions it could get worse.
Along with three increases next year, the Fed now predicts three more rises in both 2018 and 2019 as well, with rates stabilizing at a long-run “normal” level of 3pc thereafter. That’s considerably below the historic average of around 5pc. But the Fed may struggle even to get to 3pc because, under President Trump, US monetary policy will likely be even more subsumed by politics than it already is.
Since Trump beat Hillary Clinton in November’s election, Treasury yields have risen. The President-elect’s purported policies of lower taxes and higher spending are expected to boost not only growth but also inflation – which is why bondholders are demanding higher yields. It was the Fed’s symbolic confirmation it shares that view, illustrated when it raised the number of projected rate rises, that last week caused yields to rise even more.
The trouble is, though, that Trumponomics could easily backfire. In the first instance, the businessman’s “trillion dollar infrastructure spend” and other mooted ideas relating to massive fiscal expansion are in no way guaranteed to make it through Congress. Yes, the Republicans control the Senate and the House of Representatives, but both are home to plenty of fiscal hawks who view Trump as an imposter who has high-jacked their party. We could end up, once again, with legislative gridlock and even another “debt-ceiling” crisis – despite across-the-board Republican control on Capitol Hill. As such, fiscal policy could be significantly tighter under Trump than is currently expected, resulting in lower inflation and with the Fed coming under huge pressure, in turn, to keep rates low.
On top of that, Trump’s ideas on draconian border controls and his protectionist trade policies – areas where any President has far more legislative autonomy than over fiscal matters – could be extremely counterproductive. If Trump’s stump-speech plans to “deport millions” of workers and impose stringent (no doubt reciprocated) restrictions on America’s trading partners actually come to pass, they could kill this nascent US recovery stone-dead. Under that scenario too, the Fed’s stated aim of multiple rate rises is unlikely to happen.
Then, of course, there is the more general reality that financial markets remains addicted to low rates, and on-going loose monetary policy and Trump, despite his anti-Wall Street posturing, is a self-confessed “low rates kind of guy”. There is no way that the incoming President, whatever he says, will do anything that takes the gloss off US equity markets – which, pumped up on printed money, from the Fed and elsewhere, continue to test new highs.
“All the participants [of the Fed’s policy making committee] recognize there is now considerable uncertainty about how economic policies may change and what effect they may have on the economy,” said Janet Yellen last week. That was the nearest she got to commenting on the prospect of Trump’s Presidency.
If “The Donald” can get away with both ultra-loose fiscal policy and ultra-loose monetary policy, he will do that. If his fiscal wings are ultimately clipped by Congress, all the more reason for the Fed to stay ultra-loose. Either way, amid continued threats from the money-men that markets could collapse, I can’t see the Fed raising rates above 1pc by the end of 2017.