Monday, December 21, 2015

Lions who have lost their roar? The Fed's monetary policy "normalization"

Anyone watching Janet Yellen's announcement back in September (see the statement here) that US interest rates were going to remain on hold (0-0.25% target range for the Fed funds rate back then) could have been mistaken that they were living in some kind of parallel universe.  Why would the Fed be concerned about “international developments” as a reason to hold off hiking rates?  Why did the Fed appear not to be worried about the possibility of not having any ammunition to fight future economic downturns, despite the fact that it is fairly well recognized that these downturns happen every 8-12 years?  Monetary policy has been in emergency mode for 9 years, and the Fed has refused to start to properly "normalize" monetary policy, despite the fact that the US is likely entering the late stages of the business cycle, and despite the fact that most of the US economic indicators had been showing fairly robust growth for quite a while.

Despite the fact that the US economy has been on a decent economic growth trajectory for several years now, the Fed appears to have been incredibly reluctant to raise rates, as though interest rate hikes would somehow cause a dramatic weakening of economic growth.  As one market commentator put it (and I paraphrase here), "the patient is still in the intensive care unit, although he's smiling, eating candies and watching TV".  In other words, by now, the patient should no longer be in intensive care, and perhaps not even hospitalized! 

So there was little economic justification then for the December rate hike announced last Wednesday (Dec 16th) – the economic data releases are signaling an even weaker US manufacturing sector than we had in September, corporate profit growth has turned negative, and the housing sector has not taken off as might have been expected in such a low interest rate environment, particularly when the expectation of higher rates was fairly widespread.  So although most market commentators focused on the mechanics of the hike, and the new monetary policy tools that have been put in place, I really don’t think that that was the point of the hike – the Fed had signaled that it wanted a hike in 2015 and after delaying for all sorts of (what turned out to be spurious) reasons, it would have taken some pretty tortured reasoning not to raise rates in December after such a hike had been telegraphed for so long.

But that is the problem with the Fed policy right now – they have fallen behind the curve in terms of the normalization of monetary policy, and they do not appear to know how best to normalize policy in a world where monetary policy is now diverging (ECB and Bank of Japan loosening, Fed tightening) with the consequent negative effects on economic growth from deteriorating exports as the US dollar appreciates, and lackluster US economic growth. 

One aspect of the normalization is not being talked about much in the media – the fact that when loosening monetary policy the Fed lowered rates first and then enacted QE – but very little QE withdrawal has occurred and yet the Fed has raised rates again. Clearly the Fed has decided that interest rates are a better signal to markets in the event that there is a future economic downturn, but nevertheless the withdrawal of QE needs to occur before we have policy normalization.  I think it is fairly clear that full normalization will therefore not be achieved before the next economic downturn, given that the business cycle has a periodicity of about 8-10 years. 

In terms of the yield curve then, we are seeing flattening in the curve, as short rates have moved up, but long rates have moved up much less in the wake of the rate hike.  Any further rate hikes will further flatten the yield curve and may even invert it, which of course the Fed would likely want to avoid.  So there clearly is an expectation by the Fed that recent wage pressures will feed into higher levels of inflation – something that we have yet to observe.

In a way, the December rate hike publicly acknowledged that the Fed should have raised rates earlier, and that the Fed now realizes it needs to play “catch up” if certain sectors in the economy are not going to overheat, and to ensure that there is some ammunition available if we have an economic downturn in the next couple of years.  If anyone had any doubts about this, it could be deduced from the press release – the “dot plots” showing Fed expectations that rates will be raised four times in 2016 – this is clearly way out of line with Wall Street analyst expectations that only 2 rate hikes would occur.  Some analysts were puzzled that this was “hawkish” and not consistent with the “dovish” nature of Yellen’s announcement, but I think they missed the point here.

In an opinion piece published some time ago in the FT, Andrew Sentance (see here) made the point that the Fed was "falling behind the curve" in raising rates so as to return to a more normal monetary stance.  I would take that one step further - the Fed is now still seriously behind the curve in terms of rate normalization, as it should have started raising rates back in 2014 – we should be at around the 3rd rate hike in my opinion.

One interesting thing that I did hear last week was a comment by Jean-Claude Trichet that the US is in the late stage of its business cycle, but that the euro area and Japan are still mid-way through their business cycle.  But that implies that there is now not just divergence in terms of central bank monetary policy, but also “de-coupling” of business cycles between the US, Europe and Japan. This is an interesting conjecture, and I am now working on a future blog which explores this idea.

Next blog though will be my annual look at investment ideas for 2016!

Happy Christmas to all my blog readers!

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