In his latest Ahead of the Curve, Neil Williams, Group Chief Economist at Hermes Investment Management, identifies and examines the two ‘levers’ available to the US Fed and the Bank of England: raising rates and quantitative tightening (QT).
Interest rates back to normal? ‘Pull the other one’…
By leaving the Fed funds rate unchanged in September and all other buttons on its ‘policy dashboard’ un-pressed, the Fed is keeping its powder dry. But, given the underlying strength of the US labour market, the Fed’s willingness to ‘get the ball rolling’, the US’s relative insulation from China, and the prospect of some CPI uplift in 2016, the first hike looks only a matter of time, probably in December.
Two levers to pull...
Given that it will be the US’s first increase since June 2006, financial markets will doubtless then show a ‘knee jerk’ reaction and be quick to look out for more. But they must not overreact. With next-to-no headline inflation, fragile equity markets, and the global crisis still in recent memory, the Fed will move only in ‘baby steps’.
This means another two years of negative real policy rates - on top of the five we’ve had - and an ultimate ‘peak rate’ two to three years down the line much lower than we’re used to. This should preserve much of the US and UK’s growth momentum, which remain the G7’s ‘front-runners’.
China is a concern. But, while the leverage and deflation effects need watching, the Fed should not be knocked off course. US rate hikes could start in December, and then extend gradually in 2016-17.
‘True’ US & UK policy rates are as low as -5% & -2% respectively...
Our Policy Looseness Analysis reinforces the ‘Taylor Rule’ that the Fed uses for setting rates. Adjusting for the impact of QE, we estimate that ‘true’ US and UK policy rates are as low as -5% & -2% respectively. This is much lower than the officially reported 0.25% maximum for the US, and 0.5% UK Bank rate.
Taking this a step further, we gauge how far the Fed and BoE may have to pull on the other ‘monetary lever’ at their disposal through ‘QT’ (quantitative tightening). By tracking how far from their long-term averages the US and UK’s monetary/fiscal mix will lie, and using the Fed/BoE’s own interest rate/QE trade-offs, we get a handle on how much extra tightening may be needed to deliver peak rates that are below those warranted by long-run ‘neutral’ rates.
On this basis, ‘normalisation’ of interest rates in the US and UK could ultimately be secured at relatively low peak rates of 4%/2.5% respectively. Historically, US and UK policy rates have averaged about 5%.
This ‘second lever’ will be pulled only gradually to minimise the disruption to bond markets. The Fed and BoE’s likely sequencing will be to raise rates a few notches to set a buffer, before halting their reinvestment of maturing bond proceeds (i.e. ‘tightening by doing nothing’) before judiciously selling back some of the assets to financial markets.
Pulling all strands together, the major central banks still have the wherewithal to resist a global recession. There are, of course, pockets of vulnerability, with those emerging markets running excessive floating-rate US dollar debt and foreign saving needs looking exposed.
But unlike 1994, there are far fewer fixed exchange-rate pegs to protect. This, plus currency depreciations in Asia, rate cuts in Canada, Australia, New Zealand, and Norway, and QE should all limit the contagion. The ECB and Bank of Japan’s joint QE this year, at $0.75trn, would - if it works - be akin to a stimulus of up to 5% of US GDP.
This is just as well, given China’s true rebalancing is years down the line. Yet, compared to others, China’s policy position looks less acute. China still has a wide range of buttons to press on their policy ‘dashboard’ to avoid a hard landing – but they need to act. By contrast, G5 interest rates are already on the floor, and the likes of Greece are unable to devalue externally, boost fiscally, help the banks, or print money. So, given this relative advantage, the policy ball is now in China’s court.
Click here to read Ahead of the Curve