The US Federal Reserve decided to bring its monetary policy normalization to an end during its meetings on January 29 and 30, 2019. The interest rate hike cycle had kicked off slowly in December 2015 and stepped up a pace a year later, as nine interest rate hikes pushed the Fed Funds rate up from 0.25% (upper end of range) to 2.5% in December 2018. During last week’s press conference, the Fed Chair indicated that Fed Funds are now in the range of neutral, in response to the first question from journalists: there is no longer an accommodative or a tightening slant. Powell’s confidence in the strength of the US economy suggests that the end to normalization should not just be seen as hitting the pause button for a while.
The rate hike cycle has been long and slow-moving if we compare to the Fed’s previous series of tightening moves from 2004 for example. A comparison with this period also reveals that real interest rates on Fed funds were much higher then than they are now. The figure is currently marginally above the level witnessed at the start of the normalization process in December 2015, unlike the situation after 2004, when the economy was much more restricted, while this is not the case in the current economic situation.
A comparison of current real interest rates with previous phases of monetary tightening shows that today’s situation is completely different to these episodes. Real interest rates in November 2018 stood at around 0.4% (inflation figures for December are not yet available on the PCE index), which is much lower than figures in 2006, 1999 or 1990. Does this mean that the US economy is too weak to be able to deal with a real rate above 1%? This would be extremely worrying and would undermine Jerome Powell’s comments that the US economy is in a good place.
It is difficult to understand why
US normalization is coming to an end when we look at the economy, as unemployment
is near its low, so the central bank should be tightening the reins. The Fed’s
projections for 2019 and 2020 are for figures above the country’s potential
growth rate and this also fits with the economists’ consensus, at least for 2019.
Against this backdrop, monetary policy needs to be tighter to ensure that
growth does not create imbalances that then have to be addressed, and this was the
message from Powell in 2018, when he suggested that fiscal policy (too
aggressive for an economy running on full employment) would need to be offset
by tighter monetary policy to rebalance the policy mix. During the press conference
on Wednesday January 30, he did not raise this question: the issue was side-stepped,
but yet the analysis still remains the same. There are only two possible
economic explanations for the halt to normalization: either there are
expectations of a severe downgrade to projections when they are updated in
March, but this would not be consistent with Powell’s comments; or the Fed is
doing whatever it takes to extend the economic cycle at any cost, with the end
to the rate hike cycle aimed at cutting back mortgage rates and taking the
pressure off the real estate market. However, with the overall economy
remaining robust, the risk of this type of move is that it could lead to imbalances
that would be difficult to eliminate. This is the opposite approach to the Fed’s
strategy right throughout 2018, so it would be a strange tactic.
The Fed raised its benchmark rate by 25 basis points. The fed funds rate will thus evolve in the 2.25 – 2.5% corridor. This rate level is close to the corridor, 2.5-3.0%, considered by the Fed as a long-term target. This is the 4th rise this year.
The central bank does not appear worried about the pace of the economy in the coming months. Growth will slow down somewhat in 2019, but the unemployment rate will remain close to its current level, beyond full employment. Inflation will be close to 2%. It is a little weaker than at the September meeting because of the drop in the price of oil.
The Fed said it could raise its benchmark rate twice in 2019. In September, at the previous meeting, it was considering 3 rises. The pace of oil prices and its effect on the inflation rate probably explain this lessening.
Why two further hikes: the economy still operates on a trend beyond full employment. This imbalance must be offset by a monetary policy that must become a little restrictive to avoid possible imbalances, currently not very visible but that could develop in the not too distant future. The economy has changed, but not so much that it can function too long beyond full employment without having consequences that are difficult to manage in the long run. In addition, the White House policy that fuels domestic demand is resulting in a rapid rise in imports (see here). Through a somewhat restrictive monetary policy the Fed must weigh on the demand and limit the external imbalance.
The ECB puts all its energy on it but inflation does not converge frankly towards the objective (2%) it has defined. Can we say, like Mario Draghi, that the Quantitative Easing has worked properly? Yes probably on the activity. The fall of all the interest rates has modified the inter-temporal trade-off on consumers’ side favoring the immediate expenses to the detriment of the future expenses. On inflation? Yes, if the recovery helped to avoid deflation but beyond? We can wonder. Convergence towards the ECB’s target is postponed year after year. Forecasts on growth (convergence towards potential in 2021 estimated at 1.5% by the ECB) and on inflation, suggest, except to change the reaction function, that the ECB will remain accommodative for a extended time.
This post is available in pdf format My Tuesday Column – 9 October 2018
Jair Bolsonaro has come out in the lead in the Brazilian presidential elections with 46%. Looking beyond his very divisive views on certain issues in Brazilian society (status for women, LGBT), on the Paris Agreement and the corruption of previous governments, along with his aim to end Brazil’s endemic violence by allowing Brazilians to take up arms, are there any economic foundations for his likely victory? (see here the Brazilian context of these elections) This victory has very clear economic explanations. The Brazilian economy has been suffering since 2014 and the collapse in commodities prices. The recession over 2014-2015 and 2016 lasted a very long time, and was followed by a lackluster recovery, which was more of a stabilization than a real rebound. GDP in the second quarter of 2018 still fell 6% short of the 1Q 2014 figure.
This drastic situation can be attributed to two factors. The first is the country’s high dependency on commodities. Brazil enjoyed a very comfortable situation at the start of the current decade when China became its primary trading partner. Opportunities increased and commodities prices soared, so revenues were buoyant and did not encourage investment, creating a phenomenon known as Dutch disease, whereby commodities revenues were such that there was no incentive to invest in alternative businesses. But when Chinese growth began to slow and commodities prices took a nosedive, the Brazilian economy was unable to adapt, so it seized up and plunged into a severe recession.
The other factor is that Brazil devoted hefty financial resources to financing the football World Cup in 2014 and then the Olympic Games in 2016, so in a country with a massive current account deficit, this put a lot of pressure on financing. Funding for public infrastructure replaced investment in production, thereby making the country’s Dutch disease even worse.
The Brazilian population has paid a high price for the country’s brief moment of glory. Continue reading →
The Federal Reserve raised its benchmark interest rate by 25 basis points. The effective rate will evolve in a corridor between 2% and 2.25%.
The dots graph reflecting monetary policy committee members’ expectations suggests 3 rate increases in 2019, 1 in 2020 and none in 2021.
This profile, for 2019 and 2020, is unchanged from last June forecasts. The introduction of 2021, an additional year, nevertheless shows the end of the monetary tightening. It is set a final point to hardening with a slightly higher interest rate than long-term anticipation. The Fed’s rate would then evolve in a corridor ranging from 3.25% to 3.5% against a long-term equilibrium rate of 3%. The Fed needs to move above the latter to be restrictive and avoid the formation of imbalances that could harm the economy.
The press release is identical for the most part to that of June (see here the comparison). The changing part is important, however, since the Fed no longer refers to the accommodative nature of its monetary policy. It is now close to neutrality. Continue reading →
The Federal Reserve meets on September 25 and 26, and a 25bps hike to the fed funds rate is expected, putting the effective rate in a range of between 2% and 2.25%, with another hike expected in December. The Fed now seems to agree on these four monetary tightening moves for 2018, so the next big question is 2019. During the latest update of economic and financial projections from the members of the Federal Open Markets Committee (FOMC) in June, three interest rate hikes were expected in 2019. How can we get a clearer idea of what’s to come?
Four interest rates are now confirmed by the Fed. I had mentioned this scenario at the start of the year due to the White House’s implementation of expansionary fiscal policy and I have not changed my mind: the hike to the fed funds rate is just a way to iron out the imbalances caused by this policy that seeks to fuel domestic demand.
This domestic momentum reflects the impact of two factors: the first is the direct effect of tax cuts and rising public spending, and we can see the positive effects of this twofold approach for demand; the other component is trade policy that aims to use domestic production to replace imports, thereby sharply driving up demand for companies’ goods and services.
So the White House has adopted a two-pronged approach: on the one hand it bolsters domestic demand and the other it directs this additional demand towards US companies rather than imports.
This internal momentum will have at least two direct consequences: the first is the risk of inflation because demand is strong and because of higher import duties. Continue reading →