by Enrico Colombatto
The US Federal Reserve Board has finally made up its mind and will probably tighten monetary policy in the United States before the end of 2015. Will this be real monetary tightening or just a gradual retreat from the previous easy credit approach?
If these expectations are confirmed, US Federal Reserve Chairwoman Janet Yellen’s next moves will have little impact on the economy and international markets will not react. In the longer term, the satisfactory fundamentals of the US economy and adequate growth may be enough to persuade the Fed to stick to its new tightening course and, eventually, to adopt a less biased monetary view.
Most observers expect the Fed will raise interest rates in September or December 2015, following up on its repeated announcements about the need to bring the era of easy credit to an end. During the first half of the year, the economy did not perform as well as policymakers had anticipated, which is the main reason why the return to normality did not start earlier. Since Ms Yellen has steadily hinted that tightening will definitely take place within the next five months, observers’ predictions are more than just an informed guess.
At this point, the big question is no longer when the Fed will adopt a new policy, but how fast it will move and how long it will take to get the lending environment back to normal. In this case, ‘normal’ is a synonym for a lack of government interference in the credit market. The Fed’s anticipated move opens up a number of possible scenarios, depending on the pace and ultimate target of the interest-rate increases expected to begin in a matter of weeks.
The broad picture of the American economy looks brighter after the disappointing data of early 2015. Gross domestic product is expected to grow by 3 per cent this year, the unemployment rate keeps falling (to 5.3 per cent in June), the housing market is in good shape, and while the strong dollar has hurt exports, the damage to US producers from import competition has been modest.
Consumption in the US has remained lively, especially spending on durable goods. It is quite possible that some industries are benefitting from the final months of ultra-cheap credit. Why wait until the end of the year to buy a car when the purchase can be financed today at fire sale prices? Yet it is fair to say that Americans now feel optimistic about the future of the economy, and probably rightly so.
What should we expect in the short and medium run? Financial markets have already factored in the forthcoming tightening of monetary policy. For example, the prices of dollar-denominated, long-term bonds have already declined and will probably continue to do so. Yet they will not collapse unless the Fed opts for some kind of shock therapy, which is improbable, given its traditional prudence.
By contrast, the stock market keeps treading water close to its historical record level, in defiance of those experts who have been predicting a more or less imminent crash since the Dow Jones Industrial Average climbed above 15,000 points in May 2013. The explanation is that most investors aren’t convinced that the disappointing first quarter data justifies extrapolation. They believe the fundamentals of the American economy are sound and that dips in stock prices are a buy opportunity, not the alarm bell before the crash. If this pattern holds, two pieces of good news bode well for the future.
The first is that investors seem to be adjusting their medium-term investment strategies to the real features of the economy, rather than to the illusory opportunities offered by an unusually generous monetary policy. Certainly, low interest rates might have encouraged people to modify their portfolios and buy more stocks and fewer bonds. However, the recent past shows that these changes took place at the margin, affecting allocations of new capital, and did not involve major revisions of existing assets. As a result, we should expect volatility in asset prices to occur within relatively narrow ranges.
Second, most investors seem to be more sanguine about the US economy than financial experts and analysts. The difference is not surprising. While investors form their expectations and take decisions by speculating about companies’ future performance, analysts hold a retrospective focus and evaluate current asset prices with reference to past profits. When investors believe that companies are going to improve their performance, a bull market prevails, and analysts conclude that stocks are overpriced.
In order to appreciate what the future of the US monetary policy holds, one needs to consider the future performance of the American economy as a whole, and productivity in particular. This variable will make the difference between a sustainable 3 per cent growth rate for the next five years or more, and a return to the previous state of semi-stagnation.
Sustained growth would discourage the Fed from pursuing active monetary policies. Not even a Keynesian Fed needs to lower interest rates to obtain GDP growth faster than 2 per cent, which it considers a satisfactory rate. An economy expanding at that pace would also discourage overly tight monetary policy. Should inflation accelerate, import competition and the absence of ‘money printing’ will ensure that price increases remain temporary.
By contrast, if the economy once again slows in the second half, the Fed might indeed stay put after a single rate increase. This would not be a desirable move. Ongoing tampering with money and credit markets would sharpen distortions in the economy, inflating new asset bubbles that must eventually burst.
The Federal Open Markets Committee will tighten monetary policy in September, but only by a quarter point; and it will wait for at least one quarter before moving rates up another notch.
While policymakers believe that the US economy is in good health, Ms Yellen is still edgy. She is concerned about private investments, which have failed to take off; about household debt, which has increased dramatically during the past 15 years, and about the banking industry, which remains fragile in America and in most of the world.
The Fed also fears that the international context might become a drag on America. The greatest risks are posed by Europe, whose economy remains sluggish, and by China, where a real estate bubble and creeping inflation are complicating the transition to slower growth. Decision makers also know that managing the US’s large public debt (now approaching 103 per cent of GDP) is a delicate matter. A significant increase in interest rates would have severe repercussions on debt servicing and the federal budget.
Repercussions on the global scale will be more modest. The dollar might strengthen a few percentage points, but major rallies induced by interest rate differentials are improbable. Unless severe shocks intervene, the share of dollar-denominated assets in most private portfolios is going to stay stable until the end of 2015 and beyond. Nowadays, exchange rates tend to be driven by perceptions of economies’ relative strengths. Investors are unlikely to buy dollars because of fractionally higher interest rates, but they might flock to Wall Street and ignore analysts’ warnings about overpriced stocks if the American economy gathers speed.
Caveat on Europe
There is one important exception to this business as usual scenario. The exception concerns Europe’s public debt. In the past, the bailout assurances offered by the European Central Bank to the owners of government bonds have induced risk-averse investors to buy such securities, even when the returns were virtually zero. A rise in the return from dollar-denominated bonds could prompt some prospective buyers of Italian or Spanish debt to park their assets in, say, US 10-year Treasury bills with a 3 per cent coupon.
If that happens, debt servicing in Europe will become more expensive and tensions lying dormant after the Greek drama could resurface. The ECB will have to decide whether it can afford to step up its quantitative easing programme, and some national governments will need to rush through measures to fix their wobbly public finances. It is hard to imagine what might happen at that point. Perhaps the only safe prediction is that the Europeans will again be taken by surprise.
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Source: Geopolitical Information Service