Zero rates don’t add up for US Federal Reserve
New York (Mar 30) Now we know interest rates are rising in the largest economy in the world: it isn’t a question of whether, or even so much when, only how fast.
Janet Yellen, in her first Federal Open Market Committee (FOMC) press conference since taking over as chair, surprised investors by suggesting that rates can be expected to rise six months after the taper is completed and quantitative easing (QE) is done. That puts lift-off, all things being equal, at April of 2015, several months sooner than markets previously were anticipating.
Subsequent comments from Fed officials have been more about how best to characterise the perception created by Yellen, rather than clarifying or correcting it.
St. Louis Fed president James Bullard said that six months wasn’t a change of policy, and was something the “private sector” (which must somehow be distinct from financial markets) was already anticipating.
Narayana Kocherlakota, president of the Federal Reserve Bank of Minneapolis, denied the Fed was being more hawkish while San Francisco Fed president John Williams more or less said he’d not changed his view.
To be sure, the Fed will doubtless react to developments as they occur on the ground, but it is hard to escape the conclusion that, for one reason or another, it is now more comfortable with the prospect of higher interest rates.
Financial markets now see about a 50 per cent chance of an April 2015 rate hike, up from only about a 32 per cent chance a month ago. The particularly interesting thing is that this new willingness to raise interest rates hasn’t been accompanied by much evidence of an economic improvement, either in the data, which remain at best mixed, or in the Fed’s own forecasts, which are mired more or less where they were in December.
That’s bad news for risky assets like stocks or high-yield debt. Broadly, it indicates that while there aren’t macro-economic reasons to expect a better earnings environment for companies, there is a new-found chance of tighter financial markets and higher interest rates.
That goes a long way towards explaining the weak tone financial markets have taken since the Fed meeting, particularly among sectors with the most stretched valuations, like high-tech and bio-tech companies.
There is also, when it comes to rate hikes, a question of secondary importance, and that is why. Some noted that the pattern of predictions for the future level of rates from FOMC members indicated that most of the increased forecasts were from the dovish arm of the committee.
That could indicate that those Fed officials are now less fearful about some of the more extreme risks that could potentially face the economy, according to Stephen Jen, a hedge fund manager at SLJ Macro Partners. That would justify a more hawkish stance in the absence of strong evidence of improvement in the economy.
It is hardly a declaration of victory, either for quantitative easing or for zero interest rates. Instead it is more an exhausted truce with a low-growth world in which those two tools have more limited utility.
The most interesting, and potentially important, thing to come out of the Fed recently is a speech by board of governors member Jeremy Stein, in which he argues that the risk of overheating financial markets should play a bigger role in how the US central bank sets policy, even if it comes at the expense of hitting employment goals.
“All else being equal, monetary policy should be less accommodative — by which I mean that it should be willing to tolerate a larger forecast shortfall of the path of the unemployment rate from its full-employment level — when estimates of risk premiums in the bond market are abnormally low,” Stein said.
Stein presented evidence that not only does monetary policy affect risk premiums, something we’ve seen both recently and before the last crash, but that the potential for violent or sudden unwinding of overheated financial markets is not compensated fully by better growth when tight conditions normalise.
That’s an important acknowledgement that central banks can’t simply pour gas on the flames of financial markets and then avert busts with prudent regulation.
While Stein was careful to say he wasn’t arguing that markets were now overheating, his thinking about both regulation and monetary policy may be part of a new awareness of the limits of central banking.
Janet Yellen’s predecessors, Alan Greenspan and Ben Bernanke, both won adulation for monetary policy heroism despite a long-term record of boom, bust and now low growth.
Perhaps Yellen’s signal achievement will be in restoring realism. That’s probably consistent with higher rates and lower markets.