Fed must come clean over its monetary policy intentions

The US Federal Reserve has been playing cat-and-mouse with world markets for far too long.

The Fed needs to take a deep breath and commit to the next stage of its plans to normalise US monetary policy.

Unless it acts soon, it could lose credibility with the markets, harming the US dollar, risk assets and global financial stability in the process.

Fed chair Janet Yellen has a great opportunity to put a stop to the guessing game at this week’s annual gathering of world central bankers at Jackson Hole, Wyoming.

She is billed to speak this Friday and should provide better clarity on the issue that has been vexing markets since the Fed started its quest to tighten policy with its first rate hike last December.

Since then, policy has been shifted back into neutral leaving the markets at a loss on when the next rate hike is due.

The Fed’s dilemma is understandable. Conflicting domestic data, persistent global uncertainties and the looming US Presidential election in November have compounded the Fed’s quandary on raising rates again.

Surging employment but subdued inflation at home, global growth losing momentum and an urgent need to stay on the sidelines around election-time have blurred Fed’s judgement on when to hike again. Procrastination is damaging confidence.

Things are coming to a head and it is time for the Fed to draw a line in the sand and move to a proactive policy again. Judging by employment trends, the US economy certainly looks very over-cooked. With the jobless rate at 4.9 per cent and close to cyclical lows, it shows an economy surging in the fast lane of multi-year recovery. Headline US CPI inflation at 0.8 per cent may appear muted now, but the Fed must consider the consequences of leaving tightening too late and running the risk of pumping up inflation further down the road.

The latest whispering campaign suggests a September rate rise might be back on the cards. The market has been wrong-footed all too often but a move next month might be far enough away from the November elections for the Fed to avoid any criticism of political interference.

In addition, the Fed needs to consider the effects of its policy inertia in the bigger picture.

The Fed is also growing increasingly sensitive to criticisms that keeping its policy stop-valves so wide open, is heating up a very dangerous asset bubble.

The creation of so much derivative money from its QE operations has ended up funding excessive amounts of leveraged and speculative bets in world financial markets.

The Fed must be keen to limit any blame for encouraging ‘irrational exuberance’ or for putting global financial stability at risk.

But the Fed’s policy vacuum is also unsettling investors.

Mainstream equity markets may still be notching up record highs, but behind the scenes, global investors are steadily shifting portfolio exposures away from ‘higher risk’ equities into ‘safer havens’ like mainstream government bonds and cash.

Industry surveys show the equity-bond gap in global investment portfolios has fallen dramatically in recent months. It is an early telltale sign that investors are unnerved and hankering for surer-footed guidance from global policymakers.

While Fed policy should be pivoting to tougher policy, global economic considerations still favour more QE and super-stimulus from other central banks.

The lacklustre economic outlook for Japan and the euro zone suggests more monetary intervention is still needed from the Bank of Japan and European Central Bank.

And the Bank of England looks justified in trying to insure against future aftershocks from the recent Brexit vote, with more QE and lower rates.

If the Fed decides on a rate hike next month, there will be consequences. Bond markets are bound to be hit by higher rates and the global equity rally might soon start to stall.

But currency markets will read a tougher Fed as a bolster for the US dollar and set the wheels in motion for another concerted drive higher on relative interest rate considerations.

The Fed has much to weigh up and a lot of responsibility riding on its shoulders. Having borne the brunt of global recovery for much of the last seven years, the Fed is long overdue in preparing for inflation’s expected return over the future.

It is less a question of if but when US rates go up. Yellen could put the markets on amber alert for a September hike as early as this week.