Fed rate hikes and global growth
Continuing where I left off last week, I am going to emphasize here that the Federal Reserve is likely to raise US interest rates unless the US economy slows materially. Meanwhile, the economic and market fundamentals are moving in the opposite direction. I believe this indicates reactive Fed behaviour rather than anticipatory action on rates. Meanwhile, global growth signs are mixed. I will provide some anecdotes below.
On the Fed, it is clear that the Fed has a tightening bias. And with the Fed’s quantitative easing program moving into the rear view mirror, the bias toward tightening means speculation regarding when the Fed should raise interest rates. On Friday, we saw GDP data that had a price deflator of 1.4% in 2014 versus 1.3% in 2014. I believe this is close enough to 2% that Fed officials will ignore inflation and concentrate on jobs and unemployment. Note that many indications are that 2% is now a ceiling, not a target for inflation in terms of the Fed’s reaction function. There is no indication that the Fed is targeting a higher level of inflation as an overshoot. Rather, they want to be sure we are moving back toward the 2.0% level as they look to the jobs picture in adjusting policy.
Why the rush toward raising rates? The simple answer is that absent compelling reasons to remain at the zero lower bound the Fed wants to normalize interest rate policy. And Fed officials believe a normalized policy rate is well north of present levels, meaning that the Fed could raise rates and still be considered to be showing policy accommodation. An added source of tension here comes from the froth in asset markets, which is worrying the Fed regarding its stealth third mandate of financial stability. Gavyn Davies puts the reasons to worry about US equities well in a recent blog post:
the recent sharp rise in the S&P 500, relative to earnings, has raised the probability that we may be entering a bubble. This probability has still not exceeded the key confidence threshold of 95 per cent so, strictly, the verdict of the model is “no bubble”. But in February, the probability rose to 78 per cent, which is not negligible.
With this background, I believe markets are understating the potential for a Fed rate hike, or even multiple rate hikes.
That said, William Dudley, the influential NY Fed President, does give markets reason to believe the Fed will dither in his recent remarks.
The risks of hiking rates “a bit early are higher than the risks of lifting off a bit late,” he told a forum hosted by the University of Chicago’s Booth School of Business. “This argues for a more inertial approach to policy.”
But other Fed officials tell a very different story.
The U.S. economy will be operating at “full employment” by the end of this year as the unemployment rate drops to 5%, said John Williams, president of the Federal Reserve Bank of San Francisco, on Sunday.
Mr. Williams was quite upbeat about the U.S. economic outlook in an interview with Fox News Channel, echoing remarks made to The Wall Street Journal Thursday.
Citing broad-based employment gains in both low- and high-wage sectors, Mr. Williams said he believes the U.S. unemployment rate, currently at 5.7%, will fall to 5% by the end of this year. That’s a level consistent with full employment, which Fed officials see as the lowest rate of joblessness that doesn’t generate undue inflation.
“We’re seeing lots of positive developments,” Mr. Williams said. “There are lots of signs of a good consumer spending trajectory.”
Asked about U.S. inflation, which has been undershooting the Fed’s 2% target for nearly three years, Mr. Williams was also sanguine. He said the recent hit to consumer prices had been primarily driven by plunging energy costs, adding he expects inflation to stabilize and return to the central bank’s 2% goal over the next couple of years.
Business investment, which has been lagging during this recovery, should also pick up as growth persists, Mr. Williams said. He forecasts the U.S. economy will grow 3% this year, solidly above the recent trend of around 2%.
This is the story that I believe now dominates Fed thinking. And other remarks made by Dudley suggest he is more hawkish than his U. Chicago statement would have us believe. See Tim Duy’s comments here. I agree with Tim that the Fed is moving to a data-dependent policy path that will mean less forward guidance and the potential for surprises. The question then is whether how the market will react. Earnings growth and GDP growth momentum are both down. But the Fed remains upbeat. This tension can be resolved in a number of ways, either by convergence to the upside or downside or continued divergence. The worst outcome for equities and a positive scenario for government bonds is continued divergence, followed by rate hikes. The best outcome for equities is convergence to the upside. While convergence to the downside means a delay in hikes, and that would be the best government bond scenario.
Meanwhile we have seen a number of data points outside of the US on global growth. Here are pieces I would point out.
- British manufacturing PMI was best in seven months on domestic demand at 54., despite widening current account and sluggish external demand for British goods and services. British growth in 2014 was 2.6%, at the top of the heap for G-7 countries.
- In Europe, the stand out was Ireland at 57.5 on its February manufacturing PMI. Note that Ireland’s house price climb is supportive of growth. And this is a big reason we are seeing a pickup in numbers. Growth last year was 5.1%.
- Meanwhile, France is a laggard with its February manufacturing PMI down to 47.6 from 49.2 in January. While France got a green light from the EC on its budget, it was at risk because of its inability to get below the 3% hurdle.
- India is pumping in money into its economy with deficit spending on infrastructure. Finance Minister Arun Jaitley has said spending on infrastructure will increase by 700 billion rupees ($11.3 billion). That is negatively impacting the rupee, but stocks are up on the move. India is the market to watch in Asia due to its economic growth momentum.
- In China, where growth is slowing, the government is cutting rates. The last rate cut, yesterday was a surprise. And while this is normally seen as a positive, we should be concerned that it suggests Beijing needs to adopt more aggressive measures to keep the economy from slowing markedly. The PMI though hit a 7-month high in February with the HSBC number at 50.7 from 49.7 in January, with new orders picking up. Nevertheless, the 50.7 level is weak and the stimulus is the most aggressive since the crisis in 2007-09.
- On the same lines, Australian shares ended at a seven-year high today on news of the Chinese rate cut, despite the climb in unemployment, the fall in tax receipts and the cutting of interest rates after the economy’s slowing. BHP Billiton and Rio Tinto rallied as well despite signs that the iron ore glut will persist. I see Australia’s economy continuing to weaken, forcing interest rate cuts and making the government bond attractive in AUD terms and relative to equities.
Overall, global growth is still slowing, with pockets of strength. Ireland remains strong. the UK and the US are growing above average. And India looks promising. Elsewhere, the situation is less robust, in the Eurozone and in the BRICS, growth is slowing. The decline in oil prices will provide a needed boost.