Why Inflation May Overrun the Fed | Business News

Why Inflation May Overrun the Fed

23 Dec 2015 | Author: | No comments yet »

After the Fed rate hike.

The Federal Reserve aims to keep the U.S. economy running hot next year to boost the job market and inflation, a top central banker said, and to achieve that goal interest-rate hikes will be slow but will not follow any predictable pattern. “Every meeting will truly be live in terms of adjusting policy one way or the other,” San Francisco Federal Reserve Bank President John Williams told Reuters in an interview, referring to the Fed’s policy-setting meetings. When the Fed announced on Wednesday that it would raise its benchmark rate to a range of 0.25 to 0.5 percent, banks raised the rates they charge on many loans but not the rates they pay to depositors. Fed officials on Wednesday unanimously backed an increase to the central bank’s benchmark interest rate target, lifting rates from near zero for the first time since the financial crisis.

The cheer with which the financial markets greeted the Fed’s rate increase – or rather the cautious comments accompanying it about the pace of future increases – ran out of steam quickly enough. Any fair account of the Fed’s performance over that period must give the central bank great credit for helping to stem an epic financial panic and, subsequently, to stimulate renewed growth. By Friday “normal transmissions” had resumed on the markets, as weak oil prices and fears about economic growth led to equity prices falling back. As oil slipped again on Friday, investors seemed to be asking whether this was due to a glut in supply, or was it a sign that economic growth rates – and thus demand – were slipping.

That provides ample justification for the Fed’s decision to raise rates gradually, starting with a quarter-point increase en route to a projected 1.4 percent or so by the end of next year. The unemployment rate has held steady recently, at 5 percent, but the underemployment rate — which includes the unemployed, part-timers who need full-time work and jobless workers who have apparently given up looking — is still at nearly 10 percent.

Many economists have latched on to March as the most probable, in part because that would coincide with Fed Chair Janet Yellen’s next scheduled press conference. With no evidence of inflation in wages or in consumer prices, there was simply no need at this time for the Fed to risk slowing the economy by raising rates. Williams – who worked for Yellen when she ran the San Francisco Fed before handing the reins to him, and whose views are seen to align closely with hers – said his own view is in line with that expectation. But just because the Fed got away with one increase without leading to any great upheaval does not necessarily mean it can repeat the trick again in 2016.

Another rate increase could be on the cards in March or April, with a couple more slated in for later in the year, assuming the Fed sees the kind of economic growth it expects. For most of the past several decades, Fed policy makers tended to indulge these fears by giving priority to fighting inflation, even when doing so stifled jobs and wages. To keep job creation strong, rates will need to stay low, rising only modestly next year, he said, adding: “We are going to run a higher-pressure economy for a while.” If the economy springs any surprises, he said, the Fed will respond as needed. The problem is that, to work, interest rate increases have to be slightly ahead of the economic curve, and the risk for equity markets will be if growth rates subsequently disappoint, or inflation does not pick up as expected. The European Union and Japan are still engaged in quantitative easing and are keeping rates near zero or in the case of the EU, in negative territory.

Yellen, in her news conference immediately following Wednesday’s decision, also emphasized that rate hikes, though gradual, would not necessarily be all a quarter of a percentage point or evenly spaced in the calendar year. Chinese economic growth at 6.9 per cent in the third quarter is a whisker below Ireland’s GDP growth rate, having been up near double digits for a number of years. Recent comments by Janet Yellen, the chairwoman of the Fed, indicate that the increase is more to appease inflation hawks than to definitively change course. In the US, the recovery is now long-lasting, but it never seems to have reached full steam, while the euro zone still faces the familiar questions, even if the ECB has expressed optimism that its medicine is starting to work. Bernie Sanders (I-Vt.) called the move job-killing “bad news for working families.” These comments were typical of the way in which discussion of Fed policy has become polarized along with everything else.

It’s like an army that’s got all of your forces out there, you don’t have a lot of reserves,” said Williams. “It’s hard to feel like, well, I’m feeling any kind of sense of victory or something.” To be sure, there is some bipartisan consensus about the Fed — mainly in the form of congressional raids on its reserve funds to avoid raising taxes or bills supported by populists of the left and right that would subject it to spurious “audits.” Generally, though, the more the Fed necessarily involved itself in the direct management of a badly functioning economy, the more it became a political target. In fact, the risk that wages will continue to stagnate — as they have for decades for most people — should be a far more worrisome issue for policy makers than a distant and theoretical risk of inflation. Trade of the emerging world increases with China as the second largest economy of the world grows, its influence on Malaysia and the rest of Asia has become more affixed.

It is for that reason that some are speculating that emerging economies, such as Malaysia, will keep its eyes focused on what the People’s Bank of China does while having the US action in its periphery vision. “We argue that Asian central banks’ monetary policy stance next year will be more influenced by economic and monetary policy cycles in China than in the past, and will diverge from the US. The Fed would not have needed to stimulate the economy so aggressively through monetary policy if Congress had done more of the job through fiscal policy.

Unlike the previous US Fed hiking cycle when virtually all Asian central banks tightened their policies, we think this time Asian policy rates will stay lower for longer,” says Credit Suisse in a report. “Specifically, we expect rate cuts in India, Indonesia, South Korea, Taiwan and Thailand in 2016. We also project a further 75bps of rate cuts and a 200bps reduction in RRR in China. “Given the challenging environment for exports, we expect growth in trade-dependent economies including Hong Kong, Malaysia, Singapore, and Thailand to surprise the consensus on the downside.

Meanwhile, more domestic-oriented economies with policy catalysts, including Indonesia and the Philippines, could outperform expectations considerably,” it says. Just how rapidly will be important and as US rates goes up, the differential with Malaysia will narrow. “If the local economy does as it is predicted, then there is a possibility of a small hike next year but there is no urgency to do that,” says an economist. If developed market bond yields remain very low – as seems likely with a very slow hiking path, set out with some confidence – emerging market dollar yields may remain one of the few places to look for meaningful income generation for years to come,” it says. “Yields in the primary sovereign dollar index are at highs not seen since 2010, when Treasury yields were much higher than today. Yield spreads over Treasuries for investment grade sovereign debt are just under 300 basis points, and remain at elevated levels that were last seen consistently during the European crisis of 2011. High yield sovereign debt currently has a yield to maturity of 8.5%. “The divergence between developed market monetary policies has driven the dollar nearly 20% higher on a trade-weighted basis since July 2014.

Emerging market currencies have fallen in lock step. “With the European Central Bank now charting a path towards a steady dose of quantitative easing as growth in Europe stabilises, Fed predictability should help curb that dollar appreciation.

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