Can the Fed stop printing?

Central banks such as the Fed are becoming more hawkish in their growth forecasts, but they’re not about to take quick steps to end their money printing or raise rates.

Summary: On the surface, this week’s comments from US Federal Reserve chair Janet Yellen signal that is all is right with the US economy and that her above-trend growth forecasts are a precursor to the central bank ending its aggressive stimulus programs including money printing. But digging deeper, it’s clear that economic conditions remain fragile.
Key take-out: The reluctance of central banks to date to even start the process of policy normalisation suggests there is a high probability that rates won’t rise next year, despite the rhetoric.
Key beneficiaries: General investors. Category: Economics and investment strategy.

Taken at face value, some of the world central banks appear to be “hawking” things up, albeit slightly.

Leading the pack is the Bank England’s Governor Mark Carney, who noted that markets are under-pricing the risks of a near-term rate hike and that rates could go up sooner than expected. The US Federal Reserve, for its part, adopted some fairly upbeat rhetoric as well, noting in its recent statement that “growth in economic activity has rebounded in recent months.” Further, and while the Fed downgraded growth forecasts for 2014 on the back of bad weather early in the year, it remains of the view that growth will accelerate to an above-trend rate of between 3% and 3.2% next year. The unemployment rate is expected to fall further to between 5.4% and 5.7%, while inflation is expected to be around target – just below 2%.

Considering only economic targets, it’s quite clear that the Fed should and would certainly be raising rates – now even. But, then again, that has been the case for some years. At a minimum, once it became clear that deflation was no longer a threat and a depression avoided (recall these were the reasons given for engaging quantitative easing), the Fed should have started to normalise rates. More than that, both the Fed and the Bank of England have abandoned economic targets they had previously stated would trigger either an end to QE (quantitative easing) or rate hikes, once those targets looked like they were being met. This was only a few months ago, in February and March. That they did this is extraordinary, yet these decisions give investors an insight into how policy is being actually conducted at the moment.

All the actions of central banks to date, that they’ve been loath to even start the process of policy normalisation, have abandoned targets etc. – even as recovery picked up – suggests to me that there is a high probability rates won’t be going up next year, despite the rhetoric. I know this goes against the grain, but the truth is I’m not yet seeing genuine signals that central banks are preparing for an exit of ultra-stimulatory monetary policies. There are five key things to note in that regard:

1. In the first instance, and considering only the Fed for now, rate hikes and indeed the taper itself is predicated on economic forecasts being met. This is unlikely in my view. Take a look at the table below.

The Fed has forecast strong growth for 2015 of 3% to 3.2%. This is above trend and a solid rate of growth, but is not by itself unusual. What is unusual is that it’s expected to follow what the Fed forecasts will be an exceptionally strong period of growth over the next few quarters. Why do we know it is forecasting very strong growth over the next few quarters? Because it has annual growth to the December quarter 2014 at around 2.1%-2.3%. To get that, following a 1% fall in the March quarter, you need strong growth outcomes averaging 3.4% (annualised) per quarter. To get the Fed’s 3% 2015 forecast, following that growth kind of growth would be extraordinary. I’m bullish on the US, and have been for years, but that kind of growth is a stretch for me. Effectively, the Fed is forecasting uninterrupted strong growth – well above trend – for the next seven quarters.

2. Now think of the unemployment rate forecast of 5.4% to 5.7%. This is only marginally above the average rate of 5% that we saw from the boom years of 2004-07 – when we had a credit boom, a consumption boom, a housing construction boom and a global growth boom. It’s not unreasonable to suggest, given we are unlikely to see all of that repeated, that the unemployment rate settles around the high 5%s or low 6%s as a kind of new equilibrium unemployment rate. That would still be quite low by the way, the average unemployment rate over the last few decades is around 6.4%. This is especially the case given that a significant chunk of the decline in the unemployment rate has been driven by falling participation. That fall will stabilise, and when it does further falls in the unemployment rate will be harder to come by.

3. The US fiscal balance is forecast to stay around 5.6% for the next five years. That should see US debt increase by around $US1 trillion per year. The US government needs to fund that. The issue is that since the global financial crisis the Fed has bought up close to all new US Treasury issuance. Why is that going to change all of a sudden? Is the government going to raise taxes or cut spending? It hasn’t really done it to date, so why is it going to start now? Especially when a good chunk of the fiscal deficit is due to existing interest repayments, which it pays to the Fed, who then pays it back as a dividend. The government simply can’t afford to pay market rates.

4. The language of the Fed chair, Janet Yellen, isn’t hawkish. So the Fed is giving mixed signals in forecasting strong growth, but then talking things down. She notes that inflation is undershooting the Fed’s target and that: “A look at broader indicators suggests that the underutilisation in the labour market remains significant”.

5. The European Central Bank is becoming more dovish and looks set to print money.

I remain unconvinced, given all the factors above, that the Fed or even the Bank of England (which faces similar problems to the Fed), will actually tighten rates.

The Fed may end the taper, but I won’t be surprised if it doesn’t – and there is a material risk that if it does taper, then it will recommence QE if its growth forecasts are not met. That’s especially so given the ECB and Bank of Japan either are printing money, or are about to print. Such a divergence risks destabilising financial markets and, at the very least, risks huge swings on exchange rates. The only sensible way out of this predicament is for a highly coordinated exit, from ultra-low rates and quantitative easing, among central banks.

So then, why the rhetoric? In part they have had to adopt a more optimistic tone or, in the case of the Bank of England, completely backflip. Data outcomes have been very strong, and while momentum will remain positive it isn’t likely to remain as strong. It may also, in part, be driven by a desire to see more market volatility, introduce more uncertainty into decision-making etc.

The lament, widespread among policymakers, is that investors aren’t taking risks seriously enough. It is unusual for policymakers to vocalise this, as normally low volatility would be a good thing for the real economy. It’s desirable even, except when major central banks are printing money and interest rates are at record lows. Already equities (in the US and Europe) are at new records, bonds aren’t far off, and another housing boom is underway around the globe. These jawboning efforts could be an attempt to restrain that somewhat.

With all that said, the political uncertainty around policy decisions is actually quite high. So, for instance, if the US made a genuine effort at restoring public finances, or if growth surged even higher and unemployment rates did actually slump further – that would change things. I’m just not seeing any of that at the moment – and the risks are skewed the other way from here.

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