The Fed’s decision to again delay raising official interest rates in September can only be described as ludicrous in view of the fact the US economy is almost near full employment. Indeed, America’s jobless rate is a mere 5.1% and the economy is almost near fully employed.
Compared to past Fed tightening cycles, the Fed is well behind the curve – given that it had previously started raising rates from cyclical lows within months of an established downtrend in the unemployment rate.
Markets have been left debating whether US interest rates will rise at all this year. Indeed, if the Fed can’t raise rates now it’s hard to see how it can raise rates ever – as, based on its current reasoning, every wobble in global equity markets provides an excuse to leave rates unchanged.
For investors, this likely means the near-term outlook for equity prices will be upward, and the global “chase for yield” will continue. The Fed’s failure to act has also helped sustain the $A at around US 72c, and will be frustrating to the Reserve Bank of Australia. If the Fed avoid raising rates this year and the $A firms further, further local rate cuts will certainly remain on the table – especially if the unemployment rate begins to rise again and there are more signs of an investors retreat from the housing market.
Of course, there are risks to the global outlook and to the US economy – there always are. But while that may be a reason to keep interest rates on the easy side of neutral, it very hard to justify keeping rates at the “emergency” level of zero for almost 7 years.
As I’ve previously argued, the Fed’s focus on inflation seems entirely misplaced. Indeed, although the Fed is targeting a rise in inflation to 2%, history shows core consumer price inflation has rarely been at or above this level in the past two decades. Growth in the core (i.e. excluding food and energy) US consumer price expenditure deflator has averaged a mere 1.7% since the last 1990s, and has been above 2% over this period only 25% of the time.
What’s more, to the extent US inflation is low it largely reflects positive supply side effects such as the expansion in global commodity supply, globalisation and improvements in technology. America is enjoying a positive supply side shock, which is helping boost economic growth but also lower inflation.
By misdiagnosing America’s below-average inflation rates as a symptom of weak demand, the Fed is keeping rates lower than they should be – and in the process is helping underpin a likely bubble in credit and equity prices over the next year or so.
The Fed is also clearly concerned with the rising US dollar. But as the best performing major economy in the world it should not be accepting of a period of currency strength. In trying to stem the US dollars rise, the Fed is merely embarking on another round of the global currency wars, which could see both Japan and Europe embark on yet more quantitative easing.
All this is positive for risk markets in the short-term, but I fear all this will end in tears as asset prices rise to dangerous levels and central banks leave themselves little ammunition for the next inevitable financial crisis.
