Volatility in financial markets is clearly complicating expectations that the Federal Reserve will shortly move to begin normalising monetary policy.
Conventional thinking goes that the more volatile the markets become, the less are the chances that the Fed will start raising interest rates from this month. Given the experience of analysing the Fed in the recent past under Janet Yellen and Ben Bernanke this is also understandable, as both have exhibited a dovish bias, erring on the side of caution whenever there is a sign of economic or financial market uncertainty.
However, with the US economy clearly performing very well currently – a trend that Friday’s jobs figures reinforced – the main obstacle to a rise in interest rates would appear to be the situation in financial markets.
Contrary to the prevailing wisdom that fear of a Fed rate increase is causing markets to remain fragile, it may actually be the continuance of zero interest rates so long after the global financial crisis that is making markets volatile and unpredictable. In which case the sooner the Fed begins to normalise monetary policy the better it might be for both financial markets and the world economy as a whole.
Anumber of influential policy makers and commentators have opined on the implications for US monetary policy of the meltdown in Chinese markets in the past fortnight. Most recently, the IMF has warned the Fed not to make a hasty decision “with little evidence of meaningful wage and price pressures so far”. The governor of the Reserve Bank of India Raghuram Rajan has also said that the Fed should wait before tightening, while Bank of England governor Mark Carney believes that China should have little bearing on the normalisation process.
In the US, opinions appear to be becoming even more extreme, with the former US Treasury secretary Larry Summers arguing that the Fed should keep rates on hold or even restart its QE programme to counter deflationary pressures and address the turmoil in financial markets.
Bill Gross at Janus Capital, on the other hand, wants a one-off tightening in September, saying that the Fed effectively missed its window to tighten earlier this year.
Fed policymakers also sound split, with the head of the New York Fed William Dudley saying recently that a rate increase was less compelling after the China-induced turmoil, while the Fed vice chairman Stanley Fischer thinks that it is too early to say whether the market volatility makes it less or more compelling, and signalling the need to still tighten preemptively.
Increasingly, however, the level of concern over what is likely to be a relatively small adjustment in interest rates does appear to be becoming excessive. To an extent this hyper-sensitivity may also hint at how zero per cent interest rates have actually become part of the problem, rather than the solution. In fact, it might be argued that they are actually contributing to current financial markets’ instability, and arguably to low growth and low inflation as well. As Avinash Persaud said in an article in the Financial Times recently, “an overreliance on accommodative monetary policy may be one of the reasons why the world has not escaped from the clutches of a financial crisis that began more than eight years ago”.
According to this argument, interest rates have been kept too low for too long, which is contributing to excessive risk- taking and increased leverage in many parts of the world. Much of this has flowed into emerging markets contributing to bubbles, which in places like China have become unsustainable. Not only this but zero rates might even be deflationary by discouraging real investment in real assets.
Perversely, zero per cent interest rates have so skewed sentiment among some investors that many actually now hope for bad US economic data just so that the Fed will be discouraged from raising interest rates under the notion that this would be good for equities.
The reality is that it is more likely that higher interest rates will actually signal confidence about the US economy, which in turn should lead to more sustainable equity market gains over time. By contrast, the longer the Fed waits the greater the risk that confidence will slump, thus leaving it increasingly boxed in and unable to respond to future economic developments adequately.
Tim Fox is Head of Research & Chief Economist at Emirates NBD.
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