“It’s our expectation that rate increases this year will be appropriate,” said Janet Yellen last week. The Federal Reserve boss was signaling that US interest rates will keep going up.
America’s central bank has increased rates only twice in the past 10 years. The last time, though, was as recently as December 2016. If the Fed does raise rates this year too, that would be hugely significant – suggesting the global interest rate cycle has well and truly turned. It would also pose a danger that financial markets could plunge.
Ahead of the 2008 financial crisis, under the so-called “Greenspan put”, investors believed the Fed would always underpin stock and bond prices by reacting to market weakness by loosening monetary policy.
Since that crisis, in the aftermath of which interest rates were nailed to the floor, an even more extreme doctrine has emerged – that rates will be kept ultra-low. That’s what we’ve seen in recent years, with US stock indices hitting successive all-time highs and bond yields suppressed. For much of the last decade, the Fed staying put has been a rock-solid bet.
This changed slightly last December. After numerous speeches, and having previously said it would implement four rate rises during 2016, the Fed finally did raise rates – making a single move, in the last month of the year, from 0.5pc to 0.75.
For some time before, this rise was “baked into” assets prices. Had the Fed not shifted at all during 2016, it could have lost what remains of its depleted credibility. And with Trump having been elected two months before, investors could tell themselves “fiscal reflation”, “corporate tax cuts” and “big infrastructure spending” were also on the way.
Even with all that cautious preparation and mitigation, the Fed’s move still saw investors dump US Treasury bills, with yields reaching a five-year high and the sell-off rippling across the globe.
And that was despite the European Central Bank and the Bank of Japan still churning out market-soothing “quantitative easing” – and the Fed not ruling out even more virtual money-printing.
Yellen last week hinted at three rate increases in 2017. Short of saying out loud “we’re propping up equities and helping cash-strapped governments to borrow by rigging bond markets”, the Fed is running out of credible excuses not to raise.
US household spending was up 2.5pc during the final quarter of last year. GDP growth remains buoyant. Annual CPI inflation hit 2.5pc in January, with America’s consumer prices rising at their fastest pace in almost five years. It seems screamingly obvious that Fed rates of 0.75pc – still negative in real, inflation-adjusted terms, of course – are ridiculously low.
That’s why Yellen now sounds tougher – or, more accurately, slightly less ultra-cautious. “Waiting too long to remove accommodation would be unwise,” she said last week, with no hint of irony. No matter that, for years, too-low-for-too long interest rates have hammered savers worldwide and some $10,000bn of government bonds now sport negative yields. No matter that ultra-low rates, while handy for those in high-politics and high-finance, have warped capitalism, widened further the gaping chasm between those with and without property and done untold damage to “real world” business sentiment and investment.
This column said before Christmas that Fed rates won’t exceed 1pc by the end of 2017. I’m sticking with that view. US stocks remain over-valued on relatively low trading volumes – classic signs of fragility. We’re also now seeing overseas central banks rapidly offload US Treasuries – with foreign holdings down 8.4pc during 2016, a record annual decline. Both issues will weigh heavily on the Fed, despite the rate-rising rhetoric.
I also doubt we’ll see much in the way of rate rises from the Bank of England during 2017 either – not least as it faces the same problems as the Fed. UK growth is relatively healthy and inflation is rising. The Bank changed its 2017 GDP growth forecast to 2pc earlier this month, while pointing to 2.7pc CPI inflation next year. The UK economy, in no sense, justifies “emergency level” interest rates. Yet the Bank, like the Fed, is petrified the markets could take umbrage if it raises any time soon.
The Bank’s dilemma may soon become even more stark. CPI inflation rose to 1.8pc in January – uncomfortably close to the 2pc target. And there are surely further price pressures to come. Producer price inflation is now an eye-watering 20.5pc, driven by rising fuel costs. And with crude oil 60pc more expensive than it was last February, expect an UK inflation spike over the coming months.
Both the Bank of England and the Fed are stuck – damned if they do raise, damned if they don’t. While rock-bottom rates might have been justified after the financial crisis, they make no sense now. Neither does on-going QE – which, even if the Fed has stopped, is still happening, between Japan, the eurozone and the UK, at the rate of $200bn a month. No-one knows how we get out of this mess. Or what will happen if we try.
I have a suggestion. The big Western central banks, along with the Japanese, should now agree a co-ordinated rate increase, raising by enough to signal a decisive break with the past, but jointly so as to remove fears of competitive devaluation.
Cash now accounts for around 30pc of US investors’ portfolios, rising to 40c across Europe and Asia. Ultra-low rates have created a widespread tendency to sit tight. If we start raising rates, in a co-ordinated way, far from hindering growth, such dormant money could soon be put to work, bolstering growth and confidence. This strategy, I accept, is risky. But doing nothing is riskier still.
Follow Liam on Twitter @liamhalligan