Macro View: Policy divergences between world's central banks foreshadow risks of heightened turbulence

THE US Federal Reserve’s announcement on 16 December that it is starting to raise official interest rates, albeit at a gradual pace, was one of the most widely expected decisions in recent history. A December rate rise was regarded as a near certainty by the financial markets, and a sudden delay could have caused havoc.

The initial reactions were muted, even mildly positive, because most short-term effects of the Fed’s move were already reflected in market prices. Equity market falls, rises in the dollar, pressures on emerging markets, and sharp falls in high-yield bond prices occurred in anticipation of higher Fed rates. It is not surprising, therefore, that share prices rose slightly immediately after the Fed acted. But the full effects of US tightening will take time to crystallise, and will not be entirely benign. It is premature to conclude that we have seen the worst.

From a domestic US perspective, raising the target range for the Fed’s funds rate by 25 basis points, to 0.25-0.50%, was timely and justified. The US recovery is more advanced and on a sounder footing than in other major economies. Given the relatively strong US data, it is not surprising that the Fed concluded that domestic conditions are sufficiently robust for the economy to withstand the first increase in official interest rates since 2006. US GDP growth in the third quarter of 2015 was revised up to an annualised rate of 2.1%. Though this was well below the 3.9% growth recorded in Q2, and our full-year GDP forecasts remain mediocre, at 2.5% for both 2015 and 2016, the upgraded Q3 figure reinforced the view that the pace of US expansion remains steady.

The Fed’s confidence was strengthened by positive job figures. The US created 211,000 new jobs in November 2015, while the unemployment rate remained stable at 5.0%, a seven and a half-year low. This further proof of the economy’s resilience removed any lingering shred of doubt that the Fed might have had about starting to edge up rates at its mid-December meeting. But Janet Yellen still took a big risk when she pulled the trigger.

Complacent view

The view that the Fed’s move is insignificant – because a 25 basis points rate rise will not make much difference – is complacent and ignores the complex issues involved. The risks are finely balanced. Minimising the dangers of damaging the recovery is clearly a priority. But the longer official interest rates are kept at or near zero, with some rates being pushed occasionally into negative territory, the bigger the dangers of worsening speculative bubbles, encouraging excessive debt creation, and adding to the threats of future inflation.

The adoption of ultra-loose monetary policies during the seven years since the financial crisis, with massive money creation through quantitative easing (QE), may have helped to avoid financial meltdown; but it also causes serious problems that are becoming apparent. The rout in the high-yield (junk) bond market was undoubtedly exacerbated by the hyper-exuberant chase for yield engendered by the abnormal monetary conditions prevailing in recent years. The wild gyrations in oil and commodity prices have been made worse by an unhealthy speculative environment, in which interest rates are not able to perform their proper role in the efficient allocation of credit in the economy. Recent falls in the price of Brent crude below $40/barrel are now aggravating the credit problems of major sovereign and corporate entities.

So the Fed judged that the domestic US risks of taking the first modest step towards normalisation are justified. However, less robust areas of the global economy may face huge speculative attacks as a result of US tightening. Although the Fed signalled that the pace of tightening is likely to be gradual, it is not clear that vulnerable economies (eg, oil exporters, commodity producers, Brazil, South Africa, Turkey, Russia, etc.) will be able to withstand the pressures. Even economic giants such as China will have to cope with a more difficult environment. These global risks are serious and the US, in spite of its strength, will still be adversely affected if major problems occur elsewhere. Given this uncertain background, the Fed will be very cautious in its moves – future US interest rate increases will be at a very measured pace of about 25 basis points per quarter, bringing up the target range for the Fed’s funds rate to 1-1.25% by end-2016.

Opposite direction

Less than a fortnight before the Fed started to tighten, the European Central Bank (ECB) moved in the opposite direction. While leaving the policy rate unchanged at 0.1%, the ECB pushed its deposit rate further into negative territory, to -0.3%, and pledged to extend its €60bn-a-month bond buying programme for another six months, from September 2016 as currently planned, to March 2017. The markets expected the ECB to be more aggressive, and showed their displeasure by pushing the euro up against the dollar after the ECB announced its decision. In reaction, ECB president Dragi reassured the markets that, if needed, the ECB can and will do more to sustain growth, and to meet its mandate of raising inflation to the target level of “just under” 2%.

The central banks of Japan and China had, at the time of writing, not changed policy, but they are likely to continue to pursue expansionary policies. China’s central bank’s recent decision to manage the yuan against a basket of currencies, instead of pegging it solely to the dollar, would give it greater flexibility. We expect China to cut interest rates further in 2016. The UK, as is often the case, remains somewhere in the middle between the US and the eurozone. Like the US, the UK is enjoying a mediocre recovery, with GDP growth likely to continue at a pace of 2.4-2.5% per annum in 2016, coupled with low inflation, a strong labour market and falling unemployment. But the UK’s recovery is more fragile than that of the US, with weak trade and manufacturing figures. The UK is likely to start raising rates in Q3 2016, some five to six months after the US, but much earlier than the eurozone and Japan.

The current sharp policy divergences between the world’s major central banks, mainly the Fed the European Central Bank, are most unusual and foreshadow risks of heightened turbulence. Traditionally, the US has led most global cyclical upturns. The Fed was usually the first to raise interest rates, while the others followed – later and at a slower pace. At present, the US is leading a mediocre cyclical upturn and is starting a gradual process of tightening. But the eurozone, Japan and China are moving in the opposite direction, and all appear determined to continue to ease policy quite aggressively. The financial markets are trying to cope with acute uncertainties resulting from conflicting messages about global prospects. While it is not unusual for disparities in cyclical positions to require different policy responses in various countries, the current extreme divergences are almost unprecedented, and the potential confusion could have damaging consequences in 2016.

David Kern of Kern Consulting is Chief Economist at the British Chambers of Commerce. He was formerly NatWest Group Chief Economist