No reason to be afraid of the Federal Reserve putting up interest rates
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Version 0 of 1. Will they or won’t they? On Thursday next week we will get the decision of the US Federal Reserve on whether to make a start on increasing interest rates. The rise, if it comes, will be tiny – so tiny as to have virtually no direct economic effect. But because rates have been near zero for so long, any increase at all will take on wider significance. For a start, people will factor in further increases. Indeed, one of the arguments being made for an increase now is that it will reduce the speed at which such increases take place in the future. Beyond that, to move now will show that the Fed is paying more attention to domestic economic conditions, rather than international market concerns, and in particular the impact of a marked slowdown in the emerging economies. The two graphs show these conflicting pressures on the Fed. On top you see the average weekly additional people signing up for unemployment benefit going right back to the 1970s. Obviously these numbers peak in times of recession (the grey bands) and fall back as growth takes hold. As you can see, the rate at which people are applying now is right at the bottom of the range it has been for the past 40 years. Associated with this decline is the falling participation rate – people are leaving the labour market altogether – but most of the reason for it has been the steady increase in jobs. Now that the unemployment rate is down to 5.1 per cent, it is hard to argue that there is much spare capacity left in the labour market. In any previous cycle, facing this situation, the Fed would have started to increase rates already. It might well have moved towards the end of last year. It didn’t mainly because of the low inflation rate, brought about by the fall in the oil price. Now it has another excuse not to move: market disruption following the decline in the growth rate of China and much of the rest of the emerging world. Now look at the bottom graph. It shows PMIs for the developed countries and the emerging ones. These indices, derived by asking companies’ purchasing managers whether they expect to increase or decrease their buying in the coming months, give an early warning as to whether the national economy will expand or contract. Anything above 50 signifies expansion, because more than half the companies expect growth; anything below 50 suggests contraction because less than half do. As you can see, in the early stages of the recovery, in 2010, companies in both developed and emerging markets were uniformly bullish. Then sentiment in the developed world fell back, actually dipping below the 50 figure in 2012. Some parts of the developed world, notably the eurozone, did fall back into recession. But since then there has been a decent recovery in almost all the developed world. But in the emerging economies the pattern is quite different. In 2010 they were somewhat more optimistic than the developed countries. Since then sentiment has deteriorated and now the index has dipped below the magic 50. If it does not pick up, that would suggest a recession in the emerging world. The last time that happened was in the 1990s – for the emerging world taken as a whole escaped the 2008-09 recession. Now two of the BRICs, the largest emerging economies, Russia and Brazil, are in trouble. A third, China, is slowing, leaving only India driving on strongly. The Chinese slowdown could trigger a regional recession, even if China itself keeps growing. Now come back to the Fed. Among the people urging caution this week is the World Bank’s economist, on the grounds that Fed tightening would damage the emerging world. But the Fed is a US institution, making policy for the United States. There has been market contagion from what has been happening in China, in the sense that the falls on Wall Street were triggered by falls in Shanghai. But there does not seem to have been significant economic contagion, at least not yet. So what will it do? The pundits are pretty evenly divided, while the markets signal a 30-40 per cent chance of a rise – clever people can derive that from looking at the yield curve. More unscientifically, the people whose judgement I trust tend to think it will move, while those whose judgement I distrust seem to think it won’t. That would lead to this conclusion: if the markets tank over the next week they may hold off, but the balance of probability is that we should stand by for rising rates. If that is right, then what about next year? Well, a lot depends on the US labour market. The danger, and this applies to us too, is that it might tighten quite sharply. The RBC Capital Markets economics team (which on balance does expect a rate rise next week) notes that US wages are already up 5 per cent year-on-year in money terms, which implies a chunky rise in real pay too. The prospect then would be for faster rate rises than the market currently expects. That view is echoed by Capital Economics, which has warned that “regardless of the exact timing of the first rate hike, we anticipate that rising wage growth and core inflation will force the Fed to raise rates much more aggressively next year than the markets currently expect”. If that is right, and I think it is, then what are the consequences? For the US, rising wage growth will underpin rising consumption, so there is no reason to believe that the economy will slow very much. Credit costs will rise a bit, but surely not by enough to choke off consumer demand or to lead to a residential property collapse. But commercial property may struggle. Bond yields naturally will continue their climb. Quite what that would do to equities, I am not sure. Undoubtedly rising rates would be a headwind but it may be that this faster climb is already priced into the market, particularly since we can be assured that the Fed will not move rates upwards faster than the economy requires. My own feeling is that people are far too worried about monetary tightening, just as they were about fiscal tightening. It will be just fine. |