The Fed is returning to the real world of higher interest rates

Head of the central bank Yellen has put the markets on notice for an early rate rise

PUBLISHED : Monday, 30 May, 2016, 11:15am
UPDATED : Monday, 30 May, 2016, 3:03pm

It is fair to say the world economy is stuck in a very troubled state right now. Burdened by crippling financial debt, bloated by central bank super-stimulus and plagued by deepening political risks, the global economic picture looks increasingly uncertain. Global stability is living on borrowed time and in need of more than just temporary fixes.

There is little chance of world leaders riding to the rescue. After last week’s lacklustre Group of Seven summit, gone is the chance of all hands to the pumps to revive global growth. World economic fortunes are now in the hands of the US Federal Reserve, central bank to the world’s largest economy, and judging by hints from chief Janet Yellen, global markets could be in for a rocky ride in the next few months.

Yellen is definitely clearing the decks for another US rate rise after warning last week that the Fed should tighten again in the coming months, if the US economy continues to pick up momentum and jobs keep being generated. The markets should get another good insight to the Fed’s near term intentions this Friday when May’s US employment report is published.

US employment data is one of the best gauges for Fed policy leanings and the numbers should be pointing to another interest rate rise without much further ado. Market surveys are anticipating another strong set of figures with the non-farm payrolls headcount expected to add a further 170,000 jobs in May, slightly more than April’s 160,000 rise.

US labour markets have come a long way in the last seven years with the unemployment rate cut in half to 5 per cent from the 10 per cent peak hit during the 2008-2009 recession. But now US labour markets are starting to look overcooked. The Fed has been paying plenty of lip service to weak international conditions but now is the time for domestic considerations to take priority. With global energy prices pushing steadily higher, the Fed must avoid taking too many liberties with longer term cost-push and demand-pull inflation pressures.

Clearly, Yellen’s words were aimed to put the markets on notice for an early rate rise. It has made an impression on the markets with trading in US Federal funds at the end of last week factoring in a 1-in-4 chance of an increase at the June 14-15 policy meeting and a 1-in-2 chance of a hike at the July 26-27 gathering. If the Fed can get a rate rise in early enough, there may be enough time to squeeze in a further hike before the 8th November US elections, perhaps as soon as September.

Once the Fed embarks on the next round of rate rises, the worry is it sets the scene for a general tightening of US financial conditions via a stronger dollar and higher bond yields. Market sentiment will probably take a hit, but if the Fed plays its cards right and sticks to its guns, the fallout should be limited. On a trade-weighted basis the US dollar is still lower than it was after last December’s hike and 30-year US Treasury yields are also down from where they were when the Fed began tightening last year.

Any potential threat to risk asset perceptions should also be cushioned by the abundance of global liquidity generated via central bank quantitive easing (QE) operations during the last seven years. Investors need to stay invested somewhere and, while global equities may wobble, as long as the Fed plays even-handedly and assures the market that its $4.5 trillion QE asset pile is unaffected for now, the blow to financial confidence should be limited. After all, even after small incremental rises, US rates will still be highly accommodative.

The Fed knows it has to wean the markets off their addiction to cheap and easy money and return interest rates back to levels where monetary policy can have traction again. Besides, there may be a political wild card looming next year in the shape of a possible Donald Trump presidency and the Fed needs to get monetary policy proactive again to anticipate any potential shocks looming down the line. US interest rates need to reach a level where the Fed can ease again and make some difference. After all, future political factors are likely to be much less amenable to reopening QE operations.

The global economy may be living on borrowed time, but the Fed knows the moment has come to return to the real world of higher interest rates.