The US Federal Reserve (Fed) has now raised interest rates twice in recent months, in December 2016 and March of this year. The question now is, what are the Fed and other central banks thinking and what will they do next?
This is a vital question for global markets. Since the 2008/2009 credit crisis, numerous central banks have pursued loose monetary policies in order to support economic growth. While providing some support, these policies have also been a major distorting factor, pushing up the prices of all kinds of assets – everything from houses, works of art, classic cars and the prices of shares and bonds. When central banks start to change direction, asset prices are likely to do the same.
When looking at central banks, one of the most important things to keep in mind is that these institutions are run by committees. While useful, committees also have some well-known features. As the saying goes: ‘A camel is a horse designed by a committee’.
Setting aside for now the relative advantages of camels versus horses, a feature to draw attention to is that committees are renowned for being risk averse. In the case of the interest rate setting, the key is to try and determine what the committee members fear being blamed for.
Let’s apply this principle of ‘Committee Think’ to the Fed, the European Central Bank (ECB) and the UK’s Monetary Policy Committee (MPC) and make some predictions. First the Fed. It is looking at a strongly-performing US economy – with good growth, robust job creation and an inflation rate ticking higher. CPI in the US has risen from slightly negative in the Spring of 2015 to 2.7% this February, a significant overshoot of the 2% target. Committee members will fear being blamed for a sustained overshoot in inflation.
This has been brewing for some time. The Fed raised interest rates by 0.25% in December 2015, the first move since 2008. It had been looking to follow this with further rises last year, but 2016 started with a fresh round of concerns about slowing growth in China and falling commodity prices, as well as concerns over deflation. This spooked the ECB into cutting rates and introducing a huge programme of quantitative easing (QE), buying €60-80bn of Eurozone bonds every month. With the ECB cutting rates, the Fed backed off and kept rates unchanged until the end of the year. In terms of ‘Committee Think’, if there was a risk of the global economy turning down, the Fed did not want to be blamed for it.
Now roll the clock forward to the end of 2016. Consumer Price Index (CPI) inflation accelerated from 0.8% in July 2016 to 2.1% in December 2016 and the global economy was doing much better than expected. Moreover, Donald Trump was elected and promised a big fiscal boost for the US. Now the committee members were worried inflation would continue to go up and fingers would point in their direction. Members were determined to raise rates and did so at the December meeting and then went out of their way to warn another increase would follow in March. The market was not anticipating a rise in March, but ‘Committee Think’ pointed to just that.
What happens now? The US economy is still strong and inflation reached 2.7% in February. The market has woken up and commentators are predicting an aggressive series of increases through the year. But Committee Think does not work like this. Committee members have taken some steps, but will now more likely take a wait and see approach. Overly aggressive action could result in the US economy slowing and the Fed would be blamed for the slowdown. The Fed will now pause and reassess. If the economy holds up, there will be more rate rises this year, but at a slower pace. As usual, media commentary and markets swing from one extreme to another, while the answer is somewhere in between.
Finally, how does this apply to the ECB and the MPC? In both cases, the recent economic data has been good and speculation has turned to when tightening will begin. However, economic commentators are not thinking like committee members. The Eurozone has been notorious for economic and financial weakness over the last few years and the ECB has fought a prolonged battle to support it. What does it fear being blamed for? The answer is clear; the ECB is far more concerned about growth than inflation and will be in no hurry at all to increase interest rates. What about the MPC? The UK economy has been strong for several years and inflation is going up. The MPC should have been raising rates for some time. But its behaviour shows it is convinced the economy needs support, even more so in the run up to Brexit. In the aftermath of last year's referendum, the MPC cut interest rates and re-introduced QE. These decisions look to have been premature, but it clearly shows what the committee fears being blamed for. Like the ECB, the MPC is in no hurry to raise interest rates.
To sum up, to see where interest rates will go – don’t just look at the data, look at the committee.
The value of investments may fall as well as rise and investors may not get back the amount invested. This information is for professional advisers only.
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CLI00699 Expiry on 23/03/2018