Comments by new Fed chair Jay Powell in Congressional testimony, suggesting that US interest rates might rise more rapidly than the markets currently anticipate, did nothing to assuage a jittery market which has been on edge since the beginning of the month. Powell indicated that his “personal outlook for the economy has strengthened since December” which has been interpreted as an indication that the Fed may be inclined to raise rates four times this year rather than the three that markets are currently expecting.
Such a pace of tightening would then put the upper limit of the Fed funds rate target corridor at 2.5% by year-end compared with just 0.5% in November 2016. That is not quite as aggressive as 2004-05 when the funds rate rose by 200 bps in the space of just 12 months, and a further 225 bps between May 2005 and June 2006, but having got used to a prolonged period of central bank inactivity over the past decade, that would represent a big move by the standards of recent years.
In addition, the Fed has already clearly set out a path for running down its balance sheet. Last June, it announced that it would reduce its holdings of Treasury securities at a rate of $6bn per month, rising by $6bn each quarter until it reaches a maximum drawdown of $30bn per month. Mortgage-backed securities are expected to decline by $4bn per month initially, with the drawdown rate being increased by $4bn per quarter up to a maximum of $20bn per month. By the end of this year, we can thus expect the balance sheet to decline at a pace of $50bn per month (ceteris paribus) which implies a $600bn reduction per year. If we assume that the minimum size of the balance sheet required to meet the cash needs of the US economy in future is around $2.5 trillion (it is currently at $4.4 trillion), the planned rate of reduction would enable this level to be reached by the middle of 2021 (see chart). This is at the lower end of the time period given by Powell in today’s testimony, when he said that a “normal” level will be reached in “three, four, five years.”
To the extent that the US economy looks to be back on its
feet, posting solid growth and levels of unemployment consistent with full
employment, monetary normalisation is clearly desirable. But with the duration of
the US economic cycle already highly extended in the context of previous
upswings, the fairly rapid degree of policy normalisation could be one of the
factors which trips up either the economy or markets over the next one to two
years. As the economist Rudi Dornbusch once remarked, “None of the post-war expansions died of old age. They were all murdered
by the Fed.”
This also raises a question of how other central banks could or should respond. The ECB is well behind the Fed in the monetary tightening stakes, and is indeed still expanding its balance sheet even as the Fed is reducing its own. If the ECB starts to raise rates in 2019, it will be almost four years behind the US. The Bank of England may be less than happy about having to aggressively tighten if the UK economy suffers from any Brexit-induced weakness whilst the BoJ continues its extensive monetary easing. Such an asynchronous global monetary cycle might be expected to put upward pressure on the dollar. This is all very reminiscent of the situation in the late-1970s/early-1980s when Paul Volcker’s efforts to squeeze inflation out of the US economy necessitated a tight monetary stance which forced the greenback higher. This ultimately led to the Plaza and Louvre Accords of 1985 and 1987 which respectively attempted to weaken, and then stabilise the dollar.
Even today, old-timers in the FX market hark back to these agreements as an example of how to coordinate global monetary policy. We were reminded again in 2008-09 of the value of a co-ordinated policy stance. Today, we are nowhere near this position, and we can hardly blame the Fed for other central banks’ tardy efforts to remove the policies put in place in 2009 to combat conditions which are far different from those prevailing today. Whilst everything today appears to be going swimmingly, particularly in the euro zone, there will come a point where central banks elsewhere will have to start the process of taking away the punchbowl. Man cannot live by bread alone, but nor can he continue to rely on ultra-cheap credit.
This also raises a question of how other central banks could or should respond. The ECB is well behind the Fed in the monetary tightening stakes, and is indeed still expanding its balance sheet even as the Fed is reducing its own. If the ECB starts to raise rates in 2019, it will be almost four years behind the US. The Bank of England may be less than happy about having to aggressively tighten if the UK economy suffers from any Brexit-induced weakness whilst the BoJ continues its extensive monetary easing. Such an asynchronous global monetary cycle might be expected to put upward pressure on the dollar. This is all very reminiscent of the situation in the late-1970s/early-1980s when Paul Volcker’s efforts to squeeze inflation out of the US economy necessitated a tight monetary stance which forced the greenback higher. This ultimately led to the Plaza and Louvre Accords of 1985 and 1987 which respectively attempted to weaken, and then stabilise the dollar.
Even today, old-timers in the FX market hark back to these agreements as an example of how to coordinate global monetary policy. We were reminded again in 2008-09 of the value of a co-ordinated policy stance. Today, we are nowhere near this position, and we can hardly blame the Fed for other central banks’ tardy efforts to remove the policies put in place in 2009 to combat conditions which are far different from those prevailing today. Whilst everything today appears to be going swimmingly, particularly in the euro zone, there will come a point where central banks elsewhere will have to start the process of taking away the punchbowl. Man cannot live by bread alone, but nor can he continue to rely on ultra-cheap credit.
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