‘Press harder on the brakes’ could be the Federal Reserve’s next surprise move

When the US Federal Reserve, the world’s most influential central bank, unexpectedly announced in May 2013 that it was going to start winding down, or “tapering”, its programme of quantitative easing, global financial markets took a pounding.

Yet ever since the “taper tantrum” subsided in early 2014, US monetary policy has become more predictable and has no longer served as the main catalyst for periodic bouts of market turbulence. This is remarkable given that the Fed is the leading central bank furthest down the road of policy normalisation, having raised interest rates five times since December 2015 and begun the process of shrinking its US$4.5 trillion balance sheet.

It is doubly surprising given the uncertainty over the outlook for US monetary policy at a time of unprecedented change in the leadership of the Fed, with Jerome Powell replacing Janet Yellen as chairman next month and President Donald Trump preparing to fill a number of vacancies on the Fed’s powerful board of governors, including a new vice-chair. The fact that inflation is creeping up – the Fed’s preferred measure of consumer prices now stands at 1.5 per cent, still below the target of 2 per cent – only adds to the uncertainty.

Yet despite the significant risks surrounding the conduct of US monetary policy, the Fed has become a sideshow.

Over the past year or so, and especially since the beginning of this year, international investors have shifted their gaze to the world’s two other main central banks: the European Central Bank and the Bank of Japan.

Even though the Fed plans to increase borrowing costs three more times this year, recent movements in asset prices stem from expectations of tighter monetary policy in Europe and, at a later date, Japan.

The ECB’s monthly bond purchases were cut in half at the start of this year and are likely to end in September, while the Bank of Japan has expressed its misgivings about the adverse effects of negative rates and has just reduced the amount of longer-dated bonds it purchases.

For markets, the Fed is yesterday’s trade. Today’s price action is all about the ECB and, to a lesser extent, the BOJ.

The clearest example of this is the sharp slide in the dollar.

Despite a dramatic increase in the gap between the policy-sensitive yield on 2-year Treasury bonds and its German equivalent to its widest level since the launch of the euro in 1999, the dollar index (a gauge of the greenback’s performance against a basket of its peers) has plunged more than 11 per cent over the past year and on Wednesday was trading close to a three-year low. The euro, meanwhile, has shot up 15 per cent versus the greenback since mid-April to its highest level since December 2014.

Such is the intensity of speculation about when and how the ECB will start tightening the monetary spigot that investors have practically ignored the Fed.

They do so at their peril.

Firstly, traders are almost certainly getting ahead of themselves. On Wednesday, the ECB’s vice-president voiced his concern about the surge in the euro which is making it more difficult for the ECB to meet its 2 per cent inflation target. Even though the euro zone economy is growing briskly, core inflation in the bloc is still only half the ECB’s target. Consumer prices are even lower in Japan. The ECB, not to mention the BOJ, may take a lot longer to join the monetary tightening camp than markets assume.

More importantly, just as investors may be overestimating the scope for tighter monetary policy in Europe and Japan, they may be underestimating the challenges faced by a Powell-led Fed.

The sweeping tax cuts signed into law by Trump last month could deliver a significant short-term boost to growth at a time when the US economy is already at full employment. Bill Dudley, the influential head of the New York Fed, was right to warn last week that the central bank may have to “press harder on the brakes” and raise rates more aggressively.

Even if the Fed sticks to its current pace of tightening, the combination of a further uptick in inflation and worryingly stretched valuations in US equity and bond markets is bound to make Fed-watchers more nervous.

While the Fed may be a sideshow for the time being, it could quickly take centre-stage.

Nicholas Spiro is a partner at Lauressa Advisory