Published daily by the Lowy Institute

Waiting for the Fed to move

Waiting for the Fed to move

Global financial markets are on tenterhooks waiting for the US Federal Reserve to decide when to start raising the Fed funds rate – the short-term interest rate which sets the datum for many other interest rates. The media have reported this in portentous tones, exploring every possible downside risk including a repeat of the 1997-98 Asian financial crisis.

But exactly when the Fed makes its first tiny move in the tightening sequence is not very important, and should have little or no effect on the real economy, in the US or elsewhere.

The current interest rates in almost all mature economies are at extraordinary lows, with the policy rate effectively zero in many countries and even negative in some. Most accept that, with the US recovery underway, interest rates will soon begin returning to more normal levels.

But the exact timing doesn’t matter much. Janet Yellen, the Chair of the US Federal Reserve, has said again and again that the Fed will move when the time is right, and that the sequence will be gradual. Yellen has emphasised that the policy moves will be ‘data dependent’; in other words the Fed will move sooner and with more follow-up increases if the economy is seen to be expanding fast, and more gradually if the expansion is weaker. 

There can't be many investment projects whose viability hangs on the exact timing of this first decision. Nor should the decision have much impact on financial markets. If the Fed goes earlier and the sequence is faster, it means the economy is stronger, thus equity prices face offsetting factors. Current expectations about the sequence of future tightenings have already been built into longer-term yields, and the Fed’s first move won’t add much to what the market already knows about subsequent tightenings.[fold]

What about the hand-wringing over the impact on emerging markets? The last panic about the Fed’s policy prospects was the notorious ‘taper tantrum’ in May 2013. Ben Bernanke, then Chair of the Federal Reserve, told the markets something that was already widespread knowledge: that at some stage quantitative easing (QE) would come to an end. In response to this non-news, exchange rates in a number of emerging economies fell quite sharply. When active QE did come to an end later that year, financial markets hardly noticed. 

Since then, the large capital flows that went to the emerging economies during the QE period (2009-2011) have reversed, and exchange rates in these countries have adjusted downward in response. The Indonesian rupiah, for example, is down about 10% this year and about 25-30% over the past few years. That’s about the same as the fall in the Aussie dollar. In neither country has this caused great trauma. It's part of the usual commodity-price adjustment process.

What market adjustments will be necessary when the Fed makes its move? All those with vulnerable portfolios have already adjusted – hence the capital outflows from emerging economies over the past year. Those with dollar-denominated debt are already dealing with the consequences. Longer-term interest rates have adjusted to the best guess of the future.

It’s true that the tightening phase in the past has sometimes been stressful. Commentators look for guidance from the 12 Fed adjustment cycles since 1955, and in particular the 1994 tightening which came as a surprise to the bond market. But there are no surprises in store this time.

It’s also worth noting that all the early tightenings in this history took place in a very different policy environment, where it was necessary to rein in an economy that was travelling too fast. With the crude policy tools of the time, this often caused a sharp downturn. Policy instruments are now more subtle and exchange rates are flexible. This tightening can be gentle because it's not responding to runaway demand.

Commentators also point to the mistakes which policy makers have made in past tightening phases, including two recent examples: Japan in 2000 and, notably, Sweden in 2010-11. But the very fact that Yellen quotes these earlier mistakes is insurance that the Fed won’t repeat them.

In any case, even if the Fed does make a mistake and tightens too early, we won’t know that it was a mistake for some time.

Nor will this first move tell us anything about future moves, or whether the Board of the Federal Reserve is dominated by hawks or doves. Yellen is by inclination on the dovish side, but she has talked about the impending increase so many times that the move, whenever it comes, cannot be interpreted as a victory for the hawks. 

Some are arguing that if the Fed moves while inflation is still so low, this will confirm that there has been a change in policy regime – the abandonment of the implicit 2% inflation target. This, too, seems an overwrought interpretation. The mature economies have experienced an unusual, perhaps unique, period of zero-interest rates. This has distorted saving and investment decisions and leaves economies vulnerable to asset mispricing. A move while inflation is still low will confirm what we already know: that central banks are uncomfortable with near-zero interest rates and anxious to get them up off the floor just as soon as they can safely do so. Getting inflation back to 2% will take longer, but the idea of using inflation as the key guidance for setting the stance of monetary policy hasn’t been abandoned.

To argue that the exact timing of the Fed’s first move is unimportant is not to deny that there are serious unresolved issues in macro-policy. There is no disputing that the normalisation of interest rates over coming years will traverse unknown territory. There are also real concerns about possible secular stagnation. Have the mature economies lost their mojo? The recovery in the mature economies in the seven years since the financial crisis has been pathetically slow, notably in Europe. How can growing income inequality be addressed? Can China maintain the 7% growth we have all come to depend on?

In this uncertain world, why have financial markets fixated on this trivially unimportant decision? One possibility is that much of the business of financial markets – forward contracts, futures, options and so on – is a form of gambling about events which in themselves don’t affect the real economy much. But the outcome of the gamble does have great import for the players themselves. Unfortunately there is collateral damage to innocent bystanders, adversely affected by the gloom and general uncertainty produced by this fixation. Perhaps this is why emerging-economy policy-makers are now urging the Fed to just get on with it and to put an end to the confidence-sapping agonising.

Photo courtesy of Flickr user International Monetary Fund.

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