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There is a growing consensus that interest rates are going up although there is less consensus around the suitability of such actions and the pace at which they should be undertaken.
From a monetary policy perspective, we remain in unchartered waters following the unprecedented actions of central banks – namely near zero, and in some cases negative, interest rates and asset purchasing programs that have resulted in swollen balance sheets. Having fended off economic Armageddon, central banks are tactfully looking to unwind these policies without risking the hard fought economic recovery. No easy task when one acknowledges that we are yet to fully understand the true impact of these measures let alone their reversal. It’s therefore no surprise that the actions of the Fed, who are the most advanced in normalising monetary policy, are being watched with great scrutiny.
Refreshingly, and in a fitting break from convention, Jerome Powell, the new Fed Chairman, is plain speaking. This was demonstrated in his first speech in his new role when he wasted no time in directly addressing the crux of the debate around future interest rate rises in tackling the conundrum that is the Philips Curve. This theory, which is a cornerstone of modern monetary policy, dictates that the relationship between unemployment and inflation is inverse and as such falling unemployment will lead to inflation. The only snag being that there is little sign of this in the current cycle with its critics claiming technological innovation means we are in a low inflationary environment making the suggested pace of normalisation unjustified and reckless.
Whilst acknowledging that this relationship had weakened over the last decade Powell confidently asserted that he along with almost all FOMC participants believe this relationship still persists and therefore “…continues to be meaningful for monetary policy”. He even went as far as to offer an explanation for the lack of inflationary pressures despite a resurgent labour market labour market that he described as being “…in the neighbourhood of maximum employment”. Low inflation, in his opinion, was a factor of high unemployment in the early years of the recovery and more recently by falling energy prices and a strong dollar, specifically in 2015 and 2016. Whilst admitting his surprise at a lack of inflationary pressures in 2017, he cited a number of unusual one-off factors that the FOMC no longer believe to be relevant and reiterated the FOMC’s expectations that inflation will reach 1.9% this year before hitting the target of 2.00% next year.
In a robust defence of the pace at which the Fed has been increasing interest rates, Powell emphasised the need for effective monetary policy to be pre-emptive rather than reactionary given the existence of a time-lag. In his opinion, current policy has and will, allow for an orderly transition rather than risking economic stability by being forced to undertake a series of large reactionary increases.
Powell’s confidence in the Philips curve, along with his thorough review of the labour market, only increases the likelihood of four rate increases this year. Despite unemployment of 4.1% it was suggested that there was further scope for improvement given labour participation amongst 25-54 year olds was yet to reach pre-recession levels. As such, the FOMC expects unemployment to fall significantly below 4.00% - a level not seen since the 1960’s. Not an insignificant point for Powell to raise given inflation climbed from 1.5% in 1965 to 3.2% within 12 months before eventually hitting 5% by the end of the decade.
Powell’s hawkish commentary comes despite confirmation that FOMC deems the US trend growth rate to be a modest 1.8%, a level significantly below Trumps target of 3.00%. This projection being a function of weak productivity growth, which has been at its slowest pace since the second world war, and slower growth of the labour force, owing partly to an ageing population. Whilst acknowledging some of these factors were global phenomenon’s he was not shy in suggesting many were not. Highlighting the limitations of the Fed’s tools to influence these factors he issued a call to arms to policy makers to invest in education, infrastructure and research and development.
Finally, the celebrated smoothness by which he claimed the Fed’s tapering program is occurring might be seen as a veiled hint that he has ambitions of picking up the pace. Such a measure would put further upward pressure on the yield curve – most importantly at the back-end which would have implications for asset prices as well as the cost of future debt.
Whilst those calling for the death of the Philips Curve may eventually be proven right, it appears for now that it remains central to monetary policy decisions. Furthermore, the relative success at which Powell is able to normalise monetary policy only adds pressure on his counterparts in the UK and Eurozone and readers should not be surprised if these central banks decide to test the waters soon with the Bank of England likely to go next month.
The week ahead looks relatively quiet from an economic data perspective with industrial production figures (EU on Tuesday and UK on Wednesday) and trade balance data (UK on Wednesday and EU on Thursday). Neither should prove eventful. However, with various members of the ECB giving speeches this week markets will be looking for indications of when the ECB’s quiet confidence will manifest itself in policy action.
All views expressed here are the Author’s own and are based on information available at the time of writing
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