The Federal Reserve is about to increase interest rates this year, even though they were not expected to do so. The last years’ similar actions planted a seed of panic within the markets, which had disappeared only after the calm expectations on the rates were established.
However, the situation may be different after this year’s raise. The US dollar will take a great advantage, and we may get an opportunity to say goodbye to the 35-yer old bond bull market. Even in case the elections that take part this week make the situation unstable for some time, the influence of the Federal Reserve is strengthened by the current fiscal policy responses to populism.
Many people claim the Fed is showing its paper tiger side every time the talks go over raising the rates in the modern world, there they are kept pretty low due to the savings. It has backed away from raising interest rates a few times. By some measures, however, the US is at full employment. The unemployment rate is 5 per cent, and might well slide further, with wage and salary formation starting to firm up. Oil prices have doubled since January. The economy expanded by a provisional 2.9 per cent annualised rate in the third quarter and the major inventory correction that has torn chunks out of the growth rate over the past five quarters looks to be over. Weak investment in equipment remains a worry, having fallen by 4.5 per cent over the past year, but the reasons are opaque and this alone might not prevent the Fed from making a policy shift.
The global picture is less concerning for the Fed. China’s economy has stabilised thanks to large-scale credit and fiscal stimulus, for which there will be a price to pay, but not now. The government will try to prevent any mishaps before the crucial 19th Party Congress this time next year. The European economy is at least growing again, even if not at great speed, and a modest expansion is likely to continue as France and Germany and other countries go to the polls in 2017.
The conventional view is that the markets will take a Fed move in their stride. After all, they have priced in a rise in US interest rates since September without too much disruption. Yet markets, especially bonds, trade at elevated levels and the climate for financial assets may be about to change in ways that people are not expecting.
The US presidential election has the potential to unhinge global markets if Donald Trump wins. This is not just idle speculation. A recent Brookings Institution paper investigated the behaviour of equity, US bond and global currency markets around the first two presidential debates and incorporating the release of the Access Hollywood videotape. It showed that, contrary to the experience of the past 100 years, markets were more positively inclined to the Democratic nominee than the Republican, in spite of the former’s less supportive policies (for the finance industry) on the taxation of income, wealth and capital.
A Trump victory, then, might cause markets and bond yields to fall, putting the Fed back on hold. Yet his economic policies most likely would result eventually in a sharply wider fiscal deficit and a significantly higher debt trajectory, resulting in weaker bond markets. They also could lead to greater trade restraint, resulting in higher inflation.
By contrast, Hillary Clinton’s proposed economic policies are more moderate and better understood, but she, too, probably would support the use of the Federal budget to support income redistribution and new infrastructure programmes. In other words, both have an agenda to address what is fundamentally a delayed social and political reaction to the financial crisis.
This shift in macroeconomic policy would not likely be confined to the United States. Most advanced countries are reaching the end of a regime that started in 2009, in which they relied solely on unorthodox monetary policies. The Fed actually stopped quantitative easing two years ago. Nowadays, even the International Monetary Fund, the bastion of fiscal orthodoxy, is urging countries with “fiscal space” to use it to support growth and curb the excess of savings over investment that sustains low interest rates, which perversely may actually be encouraging higher savings and undermining pension fund solvency and bank lending models.
It is early days. Canada has already moved in this direction, as has Japan. As stated, both Mrs Clinton and Mr Trump have pledged to use the government’s balance sheet to greater effect. The UK’s forthcoming autumn statement probably will herald the start of a move towards some loosening in fiscal policy, and even the German finance minister, with an election looming next autumn, has said that there is scope for tax cuts and fiscal initiative. Where Germany goes in the eurozone, others will be inclined to want to follow.
The entrenched consensus is that we are stuck in a world of low interest rates. Yet it is also self-evident that if nothing changes this world is politically toxic and unstable.
I expect things to change as governments try to support economic growth and amid further attempts to address the slump in morale felt by people who, for various reasons, have grown to lose trust in and respect for our institutions. Governments would use public policy to address income, social and health inequalities and aim to produce higher levels of labour force participation, educational attainment, housing and better infrastructure.
Political regime change is bound to have profound effects on financial market structures and prices and the tide may be starting to turn in global bond markets, for example. An extraordinary 2016 would deserve nothing less.
The Fed’s next meeting will be important, as always, but it may prove to be little more than a footnote in the bigger picture.