The US Federal Reserve left interest rates unchanged at its April meeting, but they left the door open for further tightening in the not too distant future. This now is becoming a pattern.
If global economic developments remain positive, the Fed will consider tightening policy a little further.
Han de Jong Chief Economist
- The Fed is not acknowledging the feedback loops their policy steps trigger
- Either way, monetary policy is set to remain very accommodative
- Eurozone and Chinese economies are surprising on the positive side
The Fed raised rates in December and then indicated that it might raise rates another four times this year. This was consistent with the guidance they had provided in the second half of last year. Only three months later the Fed had reduced the number of likely rate hikes this year to two. The main reason for this sharp adjustment was risks from international economic and financial developments.
Recent economic data in many countries has eased fears that the global economy is heading for big trouble, with policymakers, or rather central banks, more or less out of bullets. So the statement issued by the FOMC last Wednesday expressed less concern over international risks, although it did say: "The committee continues to closely monitor inflation indicators and global economic and financial indicators". In other words, if global economic developments remain positive, the Fed will consider tightening policy a little further.
The feedback loop of Fed policy
What seems to be missing from the Fed’s communication is a reference to the impact Fed policy decisions can have on global financial indicators. When Ben Bernanke mentioned tapering in May 2013 all hell broke loose on a variety of financial markets in emerging economies. A number of currencies were hit hard and forced local central banks to tighten policy in order to support their currencies.
The guidance the Fed gave in the course of last year had a similar and even broader effect. It led to a significant capital outflows from emerging economies and, as a result, a significant tightening of financial conditions in these economies. This then led to a deterioration of global economic conditions which affected the US also, forcing the Fed to take a less aggressive stance.
The improvement in sentiment during the last two months surely is at least partly related to the Fed lowering its expected number of rate hikes. But one wonders if they are not making a big mistake thinking that the improvement in the outlook and sentiment creates space for a tightening of policy. It is not impossible that an early additional hike would have a negative impact once again on sentiment and the global outlook, particularly if the hike is accompanied by relatively hawkish statements. The deterioration of the outlook that would result from that, will, once again, force the Fed to ‘tone down’. The Fed is thus trapped in a catch-22 situation, or rather, it is caught up in a feedback loop.
The reason for this feedback loop is rather obvious, I think, and I have mentioned this before. A large amount of dollar-denominated debt has been created outside the US in recent years and US monetary policy affects these debts. In addition, many currencies are managed against the US dollar and local monetary policy is therefore also affected by US monetary policy.
The question is if that really matters? Quite a number of people I talk to worry that US inflation is about to take off. Who knows… It is true that US inflation has been higher recently than, for example, eurozone inflation despite the appreciation of the dollar since mid-2014. But there may be special factors, such as rents, driving the difference. And worries that US inflation might accelerate have time and again proved incorrect in recent years. In any event, the Fed has significantly undershot its inflation target in recent years and an argument can be made that a persistent (modest) overshoot is needed to restore credibility in the Fed’s target, or is at least tolerable.
Yellen making her mark
Another important element in this discussion is the position of Fed chair Yellen. She has presided over a Fed where views have been very divergent, but she seems to have managed to get a little more unity as there was only one dissenting vote at last Wednesday’s FOMC meeting.
One of the problems on the US labour market in recent years has been the persistent decline of the participation rate. That is partly caused by demographics, but partly by people getting discouraged and giving up. People giving up on the labour market is a problem for the economy and also a social problem. We know that the longer people are out of work or even completely detached from the labour market, the more difficult it is to get them back. In earlier work, Yellen has taken the view that a possible way to reverse the decline of the participation rate is to create a tight labour market, forcing employers to consider (retraining and) hiring people who had given up. This theory did not really seem to work, at least not until September last year. Since then, however, the participation rate has been making a remarkable recovery. That is excellent news and long may it last. As the data seems to be proving Yellen’s theory finally right, the Fed would be taking quite a gamble tightening monetary policy more aggressively than the economy and financial markets might be able to cope with.
Against this background, it is important to remember that in a speech late March Yellen mentioned that the risks to monetary tightening are asymmetric. What she meant was that if the Fed is too slow and inflation rises too much, that can be corrected relatively easily. But if the Fed tightens too quickly and the recovery falters, they will only have limited firepower to correct that.
The conclusion must be that the Fed will be very cautious tightening further. Our current view is that they will not hike at all this year. It is, however, not inconceivable that economic conditions improve sufficiently to tempt them into a rate hike later this year. One rate hike or none, the key message is that the tightening process will be extremely slow.
China and the eurozone producing positive surprises
Meanwhile, the world outside the US appears to be doing not too badly. We had already seen a broad improvement in business sentiment indicators across many countries in recent months, with some exceptions, of course. The most recent readings include an improvement in the European Commission’s index of Economic Sentiment, from 103.0 in March to 103.9 in April and a surprisingly strong eurozone GDP growth number (0.6% qoq – not annualised) for Q1.
In addition, recent Chinese data has been surprisingly strong. Chinese policymakers have provided a number of stimuli to economic activity in recent quarters and these (finally) seem to be working. Credit growth has accelerated as a result of stimulus through monetary policy while the authorities appear to have given infrastructure spending another boost, as evidenced by a sharp increase in cement sales. Developments like that do not tend to disappear quickly. It is too early to say, really, but it looks as though Chinese economic growth is accelerating a little. As my colleague Arjen van Dijkhuizen has pointed out, Chinese policymakers have fallen back to old instruments to support economic growth, pushing the can of deleveraging and making various transitions in the economy further down the road. That is not good if you look at things from a medium and long-term perspective. But it is positive in the shorter term with many countries depending on China likely to benefit.
The picture that emerges is, I think, quite encouraging. Continued modest growth of the global economy, the disasters people have feared during the last 12 months or so are not materializing and monetary policy remains very accommodative.