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Lift off! We have a lift off!

While the 0.25% increase in the US Federal Reserve’s target range for the federal funds rate on 16 December might not have the historic significance of NASA’s Chief of Public Information, Jack King’s exclamation in July 1969, as Apollo 11 blasted off for the moon, we believe it is still a significant milestone in financial market history.

One small step

The Federal Reserve has been warning for months that an interest rate hike was likely this year, with Deputy Chair, Stanley Fischer, telling markets back in May that ”we have done everything we can, within the limits of forecast uncertainty, to prepare markets for what lies ahead. Given this, markets should not be greatly surprised by either the timing or pace of normalisation.” This preparation worked well, as after all the hype and expectation, markets reacted calmly and logically after the announcement, with little change in bond yields, currencies or equities.

One giant leap?

For investors, a small, well-flagged, increase in interest rates from an emergency setting should have little impact. However, this clearly has not been the case. Markets have seen seismic shifts in the build up to the rate move, with the US dollar rallying sharply, and emerging and commodity markets under immense pressure. Investors’ focus is likely to begin to turn towards what happens now and in particular to whether the Federal Reserve is about to engineer a series of interest rate increases that significantly tightens global financial conditions further. With the labour market close to full employment, but with inflation still low, policymakers need to be confident that prices will slowly but surely rise back toward their 2% longer-term objective, as measured by the annual change in the price index for personal consumption expenditure.

The key to future developments in the United States can be found in the work of Alban William Housego Phillips, who in 1958 published ‘the relationship between unemployment and the rate of change of money wage rates in the United Kingdom, 1861-1957.’ This obscure sounding work evolved into the better known Phillips curve and forms the bedrock of the Federal Reserve’s inflation forecasting models. Quite simply, policymakers believe that, as economic slack is absorbed, wages will rise and inflation will drift back toward its target range. With personal consumption expenditure (PCE) inflation running at just 0.2%, the Federal Open Market Committee (FOMC) is placing a lot of faith in its (rather complicated) version of the Phillips curve, which states that total inflation reflects underlying, or core, inflation plus volatile food and energy prices. Core inflation, in turn, is driven by economic slack, changes in the price of imported goods and idiosyncratic shocks. Crucially, the long-term trend in inflation is ultimately driven by the long-run inflation expectations of households, markets and business leaders. Therefore, as Chair Yellen stated back in September, when she lectured in some detail on this subject “to be reasonably confident that inflation will return to 2% over the next few years, we need, in turn, to be reasonably confident that we will see continued solid economic growth and further gains in resource utilisation, with longer-term inflation expectations remaining near their pre-recession level.”

Seen through this lens, it becomes immediately apparent that the FOMC is going to be much more sensitive to economic data releases than it may have been historically. Faster progress toward its inflation target will see the pace of increases accelerate, whilst a set-back or much slower progress could see many months pass without another. If the economy grows by 2.3-2.5% next year, inflation rises to 1.5-1.7% and unemployment slips to 4.6-4.8%, then the FOMC’s target for Fed Funds will rise three or four more times. However, as Lord King of Lothbury, former Governor of the Bank of England, was fond of reminding us, economic forecasting shares many similarities with weather forecasting and the chances of the FOMC forecasts being accurate, particularly at a longer horizon, is remote. It follows, therefore, that as new evidence unfolds, markets will mark each economic data release to the Federal Reserve’s own forecasts, shifting out or bringing in interest rate expectations accordingly.

On balance, we believe this is likely to be a shallow and cautious interest rate cycle, largely because the economic headwinds Yellen refers to are so long lasting and dominant and crucially, outside of the US, these headwinds are blowing more strongly.

The view from space

Two factors have been dominating our world view in recent months. Firstly, the global economic system is being dominated by the financial cycle, as championed by the Bank for International Settlements. This can be defined as “the self-reinforcing interactions between perceptions of value and risk, risk taking and financing constraints which translate into financial booms and busts .” With the US having deleveraged somewhat and recapitalised banks, it can afford to increase the cost of money. Europe, however, is at least three years behind the US, whilst Asia, with China in particular, is at least two years behind Europe in this cycle. This has supported the US dollar as policy is eased in Europe and China and given the slow-moving nature of the financial cycle, these trends are unlikely to change any time soon. Linked to this, however, is the international role of the US dollar, and in particular how the sharp rally experienced in recent months has tightened global financial conditions, particularly for emerging markets. This will keep markets nervous over the coming months, particularly if the relatively high yielding USD continues to rally.

Splashdown?

The Federal Reserve should be congratulated on a well-executed policy change, particularly given the ‘taper tantrum’ experienced in 2013. From here, further increases will be a function of the outlook for US inflation, both realised and implied and the outlook for both the domestic and international economies. It is to be hoped that the models the FOMC rely on are better in practice than in theory, however, and the Committee has not just committed a policy mistake. On balance, this seems unlikely given the seemingly robust labour market. However, financial conditions have been tightening recently as credit markets, particularly those associated with energy, sell off. Markets are going to be even more focused on key economic releases than ever before.

 

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