Has The Fed Run Out Of Patience?

Web Posted on : Fri, 27 Mar 2015

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Last Thursday the US Federal Reserve (Fed) Open Market Committee removed the word “patient” from its policy statement. Financial markets interpreted this move as implying the Fed will raise interest rates in the second half of 2015, despite the fact that the US economy is falling further into deflation and real GDP growth is likely to have slowed significantly in the first quarter of 2015. A US interest rate hike in 2015 is also likely to worsen the significant US dollar (USD) squeeze currently underway in the rest of the world (see our commentary dated 22 February 2015). It seems therefore premature for the Fed to raise interest rates in 2015 and, if it happens, it will significantly worsen the US and the global growth outlook.

The Fed has been gradually hinting at an eventual interest rate hike in 2015 since the end of its Quantitative Easing (QE) program in October 2014. It changed the language in its policy statement last December from “considerable time” before to being “patient” about raising interest rates. Financial markets interpreted this as meaning an interest rate hike would probably take place sometimes in 2015. This was further corroborated by the Fed Governors’ own projections of short-term interest rates for 2015, pointing to a hike sometimes during the year. In the latest statement, the Fed stated that it will raise interest rates “when it has seen further improvement in the labour market and is reasonably confident that inflation will move back to its 2 percent objective over the medium term.” Accordingly, financial markets are currently pricing in futures contracts a 72% probability of at least a 0.25% interest rate increase by December 2015.

The case for a normalisation of US monetary policy is clear. After more than six years of effectively zero interest rates and three successive rounds of QE programs, which have more than quadrupled the Fed's balance sheet to USD4.5tn, the Fed is eager to reduce its accommodative monetary stance. Indeed, there is evidence that the Fed’s unconventional monetary policy has had mixed effects on the US economy, including a substantial increase in asset prices and a mispricing of risk in financial markets. An increase in US interest rates would bring about an end to this accommodative monetary policy and, with it, the negative side effects it has caused in financial markets.

Bloomberg US Surprise Index

Source: Bloomberg

Is 2015 the right time though to raise interest rates? The recent evidence on the health of the US economy suggests the answer is no. Not only is the US economy in deflation, further disinflationary pressures are mounting, given the recent strengthening of the USD and the continued weakness in commodity prices. In addition, the latest data point to a very weak growth performance in the first quarter of 2015. The Bloomberg US Surprise Index—which measures deviations from consensus expectations about US economic data—has never been so negative since the Great Recession of 2009. In fact, according to the Atlanta Federal Reserve, real GDP growth in the first quarter of 2015 is likely to slow to 0.3%, compared with 2.2% in Q4 2014. This seems hardly the appropriate economic conditions for an interest rate hike.

The increase in US interest rates would also have negative implications for the rest of the world economy. In anticipation of a US interest rate hike, the USD has strengthened sharply in recent months, leading to a significant USD squeeze outside the US. At a time when all other central banks around the world are easing their monetary stance, a US interest rate hike would further exacerbate the shift to dollar-denominated assets and leave the rest of the world economy squeezed for USD. As the history of recent financial crises shows, a USD squeeze is often the precursor of balance of payment crises in Emerging Markets.

The latest move by the Fed is therefore a bad omen both for the US and the rest of the world’s economy. If the Fed decides to raise interest rates in 2015, it could result in a further slowdown in the US economy and an additional USD squeeze for the rest of the world. Hopefully, the Fed will reconsider.

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