The Federal Reserve finally backed up its recent rhetoric by delivering the first rate increase the US has seen since June 2006.
The decision to deliver monetary policy tightening at a time of below trend global growth, subdued inflationary pressures, monetary policy easing elsewhere and a strengthening US dollar has many questioning whether the Fed will succeed in lifting interest rates by a further 1% in the year ahead as their economic projections currently suggest.
While the expected 1% increase is seen as “gradual” by the FOMC, markets don’t share their optimism, by pricing in only half that amount over the next 12 months.
The reaction, based on history, is understandable.
Firstly, the FOMC’s Fed fund rate forecasts – essentially the median view of FOMC members as to where interest rates will sit in the years ahead – has been one of the worst predictors of interest rate movements in recent years.
The first rate hike of the tightening cycle, based on the Fed’s own forecasts from early 2012 shown in the dot chart below, was initially pencilled in for early 2014. That didn’t happen, so it was pushed back to late 2014. After to-ing and fro-ing throughout last year, the first tightening was pushed back again, for 2015.
This week, at the very last meeting this year, the moment finally arrived.
After a performance like that, no wonder markets are a little sceptical that interest rates will be 100 basis points higher by this time next year.
Secondly, the Fed is certainly not the first central bank to have tightened monetary policy in the post-GFC era. The ECB, RBA, RBNZ and several Scandinavian nations have all tried to tighten policy only to reverse the moves, and then some, in the years following.
Janet Henry and James Pomeroy, economists at HSBC, posit the question many in the markets are asking themselves following the Fed’s historic rate hike: will the monetary tightening schedule evolve as the Fed currently forecast, or will it be forced to reverse the move? They write:
The key question is whether the US economy is finally robust enough not only to sustain its own recovery but also to lift world trade and global growth enough to allow the external deflationary pressures weighing on US inflation to wane. Or whether the US, via a strong USD, will simply become the latest victim of the deflationary pass the parcel which has plagued the global economy for a decade and find itself following all of the other DM central banks which raised rates but soon found they had to reverse course.
The chart below, in a report released by HSBC earlier today, tells a story. Any major central bank that has attempted to tighten monetary policy in the post GFC world has never succeeded in sustaining a tightening cycle beyond two years. Tellingly, all have now adopted monetary policy settings that are the same, or looser, than what they were prior to beginning their tightening cycle.
So will the Fed succeed where other central banks have failed, or will they suffer a similar fate? Henry and Pomeroy believe the answer on this occasion will be neither.
The outcome, we believe, is likely to be somewhere in between. The US recovery looks set to continue but the pace is expected to be unspectacular. This is likely to keep the markets guessing about how far and how fast the Fed Funds rate will rise in the coming years. To keep raising rates the Fed will need to see a pickup in inflation, otherwise the real, or inflation-adjusted, Fed funds rate will rise above the “neutral” rate – the rate which is neither expansionary nor contractionary. That would imply a restrictive policy and not just a reduction in monetary accommodation.
However, inflation in the US is not just determined by domestic demand. For much of the time that US unemployment has been falling, US inflation has been surprising on the downside, in large part because of global factors, including tumbling oil and other commodity prices; falling import prices and a strong dollar. Given that most of these are a function of global demand and diverging growth rates and policies, Fed policy will continue to be influenced by developments elsewhere. The US is not a closed economy.
In line with current market pricing, Henry and Pomeroy predict that the Fed will deliver two 25 basis point rate hikes in 2016, using the film ‘The Great Escape’ to explain their view.
“We are well aware that the film, The Great Escape, didn’t end particularly well. Most of those who escaped were either re-captured or worse,” they wrote.
“Our central forecast has a slightly happier ending of an ongoing global expansion, albeit at a weak nominal growth rate. However, the dwindling list of policy options that would have to be considered if things go wrong, reinforces our expectation that the Fed will tread very carefully in the coming year. The FOMC is still projecting 100bp of rate rises in 2016. We are forecasting that they will actually move more cautiously – with only two 25bp increases – rather than risk having to make the Great Reversal.”
While unspectacular and cautious, should they be proven right, it will not only be a win for the Fed but also the global economy as well.