Monetary Policy: When The Policy Rate Is Not The Policy Rate

23 Dec 2015 | Author: | No comments yet »

Fed hike clears path for Bank of England, but not right away.

Mexico City • Mexico raised borrowing costs for the first time since 2008 following Wednesday’s increase by the Federal Reserve amid concern a smaller rate advantage versus the U.S. could lead investors to pull funds from Latin America’s second- largest economy. The rise that finally did take place on Wednesday was well signalled to markets that cheered the rise, with Dow, Nasdaq and the S&P all climbing on the day by more than 1%. Banco de Mexico’s board, led by Governor Agustin Carstens, boosted the overnight rate 0.25 percentage point to 3.25 percent Thursday from a record-low 3 percent, as forecast by 21 of the 26 economists surveyed by Bloomberg.

Agustín Carstens, who also chairs the policy advisory committee of the International Monetary Fund, said Thursday the orderly reaction so far in emerging markets to the U.S. Federal Reserve’s rate increase could be sustained, noting that the coming moves will likely be less transcendental. “A very important thing is that this first step taken by the Fed had taken on a mystical quality, but I think that in subsequent actions taken by the Fed that characterization won’t apply,” said Mr. Crucially for Carney, it allows him to assess how the U.S. economy and markets react to costlier borrowing before making what will be a sensitive move of his own.

The so-called ”dot plots”, which show the interest rate forecasts of all 17 attendees at the Federal Open Market Committee meeting, suggest that there will be four more rate rises in 2016. The British economy is likely to be among the world’s fastest-growing for a third year in a row next year and, just as in the United States, it has seen a drop in unemployment. But faced with near non-existent inflation, sluggish wage growth and ultra-loose monetary policy in Britain’s main euro zone trading partners, Carney has already stressed he would not necessarily move in step with his Fed counterpart Janet Yellen.

The latest signals from the Bank of England’s Monetary Policy Committee (MPC) have indicated that we should not expect a rate rise in the near future. Carstens said the Fed managed quite well its first rate increase in almost a decade, explaining ahead of time and in detail what it intended to do, which contributed to an orderly reaction in many emerging market currencies. The central bank has spent about $24 billion in 2015 on intervention programs to support the currency. “The central bank has been watching the Fed very closely and preparing the market for this.

The peso, the world’s eighth most-traded currency with a daily volume of $135 billion, strengthened after the widely anticipated Fed decision and closed little changed Thursday at 17.06 per dollar. Recent statements from Mark Carney and his deputy, Minouche Shafik, have reinforced the view that the UK will not be in a hurry to follow the lead of the US Fed.

In the period since the onset of the great recession every central bank that raised rates, including those in Sweden, Denmark, Canada, Switzerland, New Zealand and Israel were forced to reverse course when their economies slowed and it became clear that they had raised too soon. Other Latin American currencies, such as the Brazilian real, have also strengthened. “I think that for the time being the solid response can be sustained, but there is constant news that could have an impact on markets,” Mr. Aside from the inflation outlook, there are plenty of other reasons Carney might be cautious – not least Britain’s in-out referendum on its EU membership due by the end of 2017, and finance minister George Osborne’s plans for further spending cuts as part of his mission to run a budget surplus. Thursday’s rate increase brings to an end an almost seven-year period beginning with Carstens’s predecessor, Guillermo Ortiz, in which Banxico cut rates 11 times as the economy struggled with the global financial crisis and its aftermath.

The latest Reuters poll of economists indicated that the first UK interest rate rise would take place in the second quarter of 2016 (April to June) – so could be only a few months away. Many economists anticipated that Mexico would follow the Fed after Banxico in July changed its meeting schedule for the rest of 2015 to be able to better react to U.S. moves. But as his predecessor Mervyn King – who was criticised for responding too slowly to the 2007-9 crisis – found out, the exact timing of any move is a delicate balancing act.

Carney’s previous hints of a British rate rise have been knocked off course by the twists and turns of the world economy, including the plunge in global oil prices which at one point sent British inflation tumbling to below zero. My main concern is that it is especially hard to understand the rate rise,given that the Fed has a dual mandate – to maintain stable prices and to maximise employment.

It signaled that the pace of subsequent increases will be “gradual.” The peso plunged 23 percent in the past year and a half through Wednesday, reflecting the decline in oil prices and expectations for higher U.S. borrowing costs. Carstens, who ran unsuccessfully in 2011 to head the IMF and has left the door open to try again next year when Christine Lagarde’s term ends, praised the Fed’s handling of a process of monetary normalization that will gradually end the age of easy money that started after the 2008 financial crash. “The Fed is acting in a way that’s congruent with its mandate and with the communications it has been carrying out for many months. The bank raised rates in a bid to keep the peso competitive, but annual inflation is at 2.2%, the lowest level in 45 years, and economic growth remains moderate. Growth and inflation in both the UK and US are also projected at similar rates, with GDP rising by between 2pc and 2.5pc and inflation moving back up to 2pc as the impact of lower oil prices drops out of the calculation. Unfortunately, inflation expectations may continue to decline over coming quarters, especially if actual inflation remains subdued or drops even further.

My Dartmouth colleague Andrew Levin, who was an adviser toJanet Yellen and Ben Bernanke, has suggested, and I agree, at this juncture it is imperative for the Fed to reframe its policy strategy and shore up the credibility of its inflation target. One way of doing that would be to de-emphasise the role of inflation forecasts, which have been persistently wrong over the past few years and instead to link the timing and pace of policy normalisation to actual outcomes for inflation and employment.

France continues to be a drag on European growth, but this is offset by better performance in other countries in northern Europe, such as Poland and Sweden. There has also been a rise in underemployment – measured by the number of workers who are part time for economic reasons – and this remains well above pre-recession levels. And there are signs that these are feeding through into wage increases – for example, pay rates are now increasing by over 6pc in the construction sector.

So UK borrowers and savers should keep a close eye on monetary policy on the other side of the Atlantic if they want to know what is going to happen here.

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