In December 2015, after over 2 years of procrastination, the US Federal Reserve delivered a 0.25% increase in official interest rates, the first in nearly a decade. The rise is symbolic, intended to signal the end of the crisis and a start of normalisation. But already events have cast doubts on the wisdom of the decision.
The rise will have minimal effect on consumption and investment. Analysts have already moved beyond the well-telegraphed decision, focusing on the future trajectory of American monetary policy. Instead of ‘considerable’ and ‘patient’, the focus is on the meaning of ‘gradual’.
The Fed’s forecasts project around 4 additional rate increases in 2016 and a similar number in 2017. This would mean that US official rates would be around 1.375% and 2.375% by the end of 2016 and 2017 respectively. The median estimate for the longer-term federal funds rate is around 3.5%. While this is well below the rate of over 5% in 2007, the rate of increase and the target rate are significantly greater than market expectations.
Recent developments suggest that several factors may dictate a more gradual rate of increase than the Fed’s expectations.
First, economic activity is patchy. The Fed has elected to accentuate the positive; solid employment growth, strong auto sales and improvements in housing. It is ignoring weaknesses in manufacturing, high inventory levels and uncertain consumption.
Job creation remains uneven. The decline in the unemployment rate is exaggerated by lower participation rates. Employment as percentage of population is around 59%, the same as in the 1980s well below its peak of 63%. Wage growth is minimal.
The recovery was underpinned, in part, by the domestic energy boom. The retrenchment of investment and employment, driven by low oil prices and financial problems, will continue to be felt for some time to come. The benefits of a weaker dollar and exports to strongly growing emerging markets is now reversing.
The recovery in housing prices is reliant on low rates and faces structural problems. Rising prices have reduced affordability. High levels of student debt, limited job opportunities, the need for mobility and a generational change in attitudes to borrowing may limit demand and reduce activity.
Second, the Fed’s preferred inflation measure is well below its 2% target. A stronger dollar (a 10% rise in the dollar reduces core inflation by 0.50%) and lower commodity, especially oil, prices are likely to keep inflation low.
Long term demographics are poor and are likely to adversely affect growth and may be deflationary.
Third, US debt levels are high. A 1% rise in rate will increase interest costs by around US$400 billion. Government interest costs alone will rise by around US$180 billion, widening the deficit and requiring additional public borrowing.
Fourth, the natural interest rate may be lower than prior to the crisis. Taking into account low growth and current debt levels, the real interest rates may be around 0.50%. When combined with disinflation or deflationary pressures, the long term normalised Fed Funds rate may be closer to 2% than 3.5%.
Fifth, risk is increasing. The current economic expansion has been in progress for 78 months, longer than 29 of the 33 expansions the U.S. economy since 1854. It is unclear whether the current tightening will exacerbate the downturn of a business cycle which has already lost momentum.
Financial asset prices are vulnerable to rate increases. Equity markets have tripled in this cycle. Corporate earnings are weakening. Final quarter 2015 reported earning to date have been lack lustre with sales and earnings downaround 3-4% for the S&P 500 index. Problems in debt markets, especially in high yield bonds issued by energy companies as well as emerging market debt, are already evident.
Sixth, an external shock such as worsening European debt problems cannot be discounted. The major international concern is emerging markets. A rapid slowing in growth reflects weak export markets, low commodity revenues, high debt levels and unresolved structural weaknesses. Falling local currencies and large capital outflows are likely to expose problems on uncovered foreign currency, primarily dollar denominated, debt. Higher US rates and a stronger dollar will accentuate the problems. The problems in export markets is evident in the results of automobilemanufacturers, where around 80% and 100% of Ford’s and GM’s earnings respectively emanating from North American operations.
The key issue is the US dollar which has risen by around 20% in the last year. The consensus is that the start of the tightening cycle will limit further rises. Whatever the historical pattern, the aggressive action of other central banks, especially the European Central Bank and Bank of Japan, to weaken the Euro and Yen to boost their economies may mean further appreciation of the US currency. A wild card is China. A weak domestic economy may encourage devaluation of the Yuan.
Further rises in the dollar will affect US competitiveness and exports. With about 40% of S&P500 revenues and 25% of profits generated overseas, it will affect corporate earnings. In the last quarter of 2015, most sectors, including technology and consumer staples, saw lower profits, in part because of the strong dollar.
Recent history of attempted rate normalisation is troubling. Since the crisis, central banks have found it difficult to increase and maintain higher rates. Central banks in the Eurozone, Sweden, Israel, Canada, South Korea, New Zealand and Australia have all tried and failed. In the early 2000s, the Bank of Japan also had to reverse course after raising rates.
Ancient history is worse. In 1936, the Fed tightened rates when the economy was already in recession contributing to the second part of the Great Depression and a 50% collapse in the Dow Jones Industrial Average.
Having waited to normalise rates, it is possible that a combination of events may force the Fed to reverse course. If such a change occurs, then the effect on the Fed’s standing and authority would be significant. Given financial markets now are largely driven by a belief in central bank’s ability to support the economy and asset prices, any loss of confidence in policy makers could trigger a decisive shift and trigger the inevitable reckoning that is imminent.
© 2016 Satyajit Das