Why the Federal Reserve should pull the trigger and end policy paralysis this week

The US central bank needs to set November’s US Presidential elections to one side and start thinking about domestic considerations

PUBLISHED : Monday, 19 September, 2016, 9:58am
UPDATED : Monday, 19 September, 2016, 10:35pm

It is time for the Fed to stop muddying the waters and come clean on its true monetary policy intentions. Another interest rate tightening is long overdue and no better time to get Fed policy back in traction again with an unequivocal rate hike signal this week. The market expects it, the US economy needs it and it could do the Fed’s policy credibility a world of good.

The Fed has skirted round the issue of higher rates for far too long and for a myriad of reasons. Weakness in the global economy, the risk of a hard landing in China, turbulent financial markets, Brexit fallout worries and domestic uncertainties have all provided good excuses for the Fed to sit on its hands since last December’s inaugural US interest rate rise.

The market is ill-prepared for a move so soon thanks to the Fed’s mixed messages

The longer the Fed has delayed grasping the monetary mettle, the more it has risked its own credibility. It has vacillated far too long, it needs to set November’s US Presidential elections to one side and start thinking about domestic considerations. The US is approaching full employment, the economy is expanding at a comfortable pace and domestic inflation pressures are starting to stir. The Fed would be rash to leave raising rates too much longer.

Last week’s US inflation data definitely leaves the Fed something to rue over. August consumer prices rose more than expected, rising 0.2 per cent, with the cost-of-living index pushed up by surging health-care and housing costs. This bumped up the headline inflation rate to 1.1 per cent, with core prices gaining 2.3 per cent over the last 12 months.

US deflation risks are a thing of the past, so now the Fed must start thinking about the build-up of future inflation pressures, especially with the economy on a sound footing and the monetary accelerator still being pressed hard to the floor. It may seem remote right now, but the Fed has a duty of care to avoid overheating risks down the line. US interest rates set just above zero seem out of line with the US jobless rate running close to a 10-year low.

It would be preferable to get this second rate rise out of the way as soon as possible and no better time than this week, well ahead of November’s presidential elections. But the market is ill-prepared for a move so soon thanks to the Fed’s mixed messages. Right now, market polls suggest the probability of an imminent hike is more like 70 per cent in favour of a December move, once the elections are over and the Fed can avoid accusations of political bias.

What should be expected this week is the likelihood of a “hawkish hold”, putting the markets on amber alert for higher rates just as soon as November’s election is out of the way. A more aggressive Fed bias should be a shot in the arm for investors expecting the US dollar to push higher again. The dollar’s long term rally has been stranded for far too long and a breakout is well-overdue.

Certainly from a fundamental perspective, the US dollar should have a lot more going for it than the other major currencies, based on relative interest rates, bond yields and growth expectations. It just needs the right trigger to set the trend back in motion again. A Fed signalling unambiguous rate tightening intentions should be enough to set the ball rolling again.

While the Fed is opening the door to higher rates, the European Central Bank, the Bank of Japan and the Bank of England are all giving the nod to lower rates ahead. Relative yield spreads are already working in the dollar’s favour with 10-year US government debt yielding about 170 basis points over equivalent bonds in the euro zone and Japan and about 80 basis points over Britain. Meanwhile US GDP growth running around 2 per cent continues to be dollar-positive relative to lacklustre economic expansions in Europe and Japan.

The key for the Fed is maintaining a “Goldilocks” tightening bias over the coming months. Hinting at “not too much” and “not too little” rate tightening is the right approach for a central bank committed to getting its monetary credibility back on track again.

At some stage the Fed will need to get official interest rates back into a “normalised” range of between 2 and 4 per cent in the next few years, for US monetary policy to reign supreme again.

David Brown is chief executive of New View Economics