DEBATE: The Fed moves, should there be a shift towards alternatives?
Moderator: Noel Hillmann, Managing Director, Clear Path Analysis
Panellists:
Jeremy Lawson, Chief Economist, Standard Life Investments
Bob Baur, Global Chief Economist, Principal Global Investors
Daniel Morris, Senior Investment Strategist, BNP Paribas Investment Partners
Noel Hillmann: Considering the volatile start to the year, both in emerging markets and commodity sectors, was the Federal Reserve’s decision to raise interest rates a good timing call or a decision taken too early?
Jeremy Lawson: With the information that the Federal Reserve (“the Fed”) had available at the time it seemed like a reasonable call to make as financial stress had settled somewhat after the volatile months of August and September.
The Fed had made further progress on their employment mandate and at the time it did look as though the economy had skipped a beat through much of the second half of the year although they didn't have the Q4 Gross Domestic Product (“GDP”) data at the time.
Their models had been telling them that underlying labour costs and inflation pressures would start to pick up and the evidence that has been provided so far has been consistent with that.
From this narrow framework it is fair to say that the Fed was right to begin the normalisation process.
What the Fed misunderstood, and what has been picked up by some of their officials, is that a significant negative feedback loop has developed between tighter Fed policy, the stronger dollar, financial markets, global economic growth and inflation.
Although the Fed funds rate increased for the first time in this cycle in December, the Fed actually began to tighten significantly as soon as they began to taper their asset purchases. This can be seen in the sharp increase in the Shadow Federal Funds Rate (“SFFR”) (which takes account of the impact of quantitative easing) and significant increase in the trade weighted dollar since early 2014.
As the dollar appreciated significantly financial conditions tightened across many emerging markets, weighing on growth, encouraging capital outflows and contributing to increased financial stress that was already being pushed up by deteriorating growth in China and the unwinding of the commodity boom.
As was clear from last week’s meeting, the Fed is rightly much more nervous when it looks at the global economy and financial markets, as historically increased financial stress has fed through to weaken the real economy.
Keeping policy loose for longer does increase the risk that they will temporarily rise above 2% but having missed their inflation target for so long, a period of above target inflation wouldn't be the worst mistake that they could make!
On the other hand tightening too aggressively would be a big mistake given the poor shape of the rest of the world and fragility of financial markets.
All in all this episode demonstrates just how complicated it is for the world’s most important central bank to begin normalisation policy on its own when much of the rest of the world needs easier monetary policy.
Bob Baur: Actually, if anything, the move may have been a little too late as we are getting late in the business cycle and more typically the Fed starts its monetary transition a little earlier, so it could have happened a while ago.
It is possible that the Fed it is a bit behind the inflation curve; the price deflator for core personal consumption expenditures is rising at a 1.8% pace, up from 1.7% at the prior reading and 1.3% not long before that. This 1.8% rate is very near the Fed’s target. The core consumer price index is 2.2% and accelerating, wage growth is picking up fairly nicely, labour force participation rate is coming up and labour slack is clearly shrinking so it was timely on the Fed’s part to get started.
It is true that the rate hike has been hard on emerging markets. However, this is less a result of the Fed and more a result of the strong dollar which has already been surging for 18-20 months. Liquidity has been shrinking but the strong dollar is really helpful in some sense for emerging markets as it is re-distributing the reasonably robust growth in the U.S to the rest of the world, which is positive.
The volatility in January and February didn't really have anything to do with the Fed’s decision as this was the final capitulation of the plunge in oil prices and the strong dollar.
Daniel Morris: We don't see it as a dramatic or gross policy error. I tend to agree that if they had done it in September, certainly without the comments they gave relating to concern about external factors, it would have given us less volatility subsequently. When they raised that as a more prominent concern then we had anticipated we were then left thinking, ‘what did they feel about the external markets and how that would reflect their decisions’. This means that there is much less clarity on what the path is going to be going forwards.
From a fundamental U.S economic growth point of view, it was justifiable even back in September to have done a hike. Whether this would have necessarily prevented the volatility in the markets that we saw at the beginning of the year is not necessarily true.
There was never going to be an ideal time for them to suddenly go from these very low interest rates to a hike without it having some kind of impact.
This is an excerpt from the full debate which was featured in the Spring issue of CLARITY newsletter - which you can access here.
