Washington, AFR Correspondent
Investors around the globe have been on edge waiting to see if the US Federal Reserve will hike American interest rates for the first time in almost a decade. But now a new focal point is resolving, which is more to do with the trajectory of rates once they start rising than on timing of the first move.
Former Fed vice chairman Donald Kohn, an esteemed economist who sat alongside Fed chairwoman Janet Yellen on the interest rate committee, says it is “not such a big deal” if the Fed lifts rates on Thursday.
“Whether it’s September or later in the year isn’t important,” Mr Kohn said in Washington.
“What’s important is the path for interest rates once they start to increase.”
Many traders on Wall Street aren’t so relaxed. For the thousands of fund managers around the world betting on bonds, currencies and other securities linked to interest rates, the timing of the Fed “lift off” is crucial.
Some investors stand to win or lose big wagers on whether Dr Yellen and the 17-member Federal Open Market Committee tightens monetary policy at the end of the September 16-17 meeting or waits until upcoming meetings in October or December.
Timing ‘matters’
Hedge funds also contend that if the Fed defies market expectations and lifts borrowing costs on Thursday, investors could be spooked.
Julia Coronado, chief economist at $ US10.6 billion hedge fund Graham Capital, said “the timing actually does matter very much”.
“The Fed would not want to surprise markets,” Ms Coronado said.
“When the Fed decides that now is the time to begin that process, the message and the moment matter very much to whether the markets say ‘yes this is the right and good policy’ or ‘this is a policy mistake’.”
A premature rate rise may signal the Fed is placing greater emphasis on the strength of the American economy and the low 5.1 per cent unemployment rate, rather than weak inflation and instability in the international economy.
Balancing act
The split between traditional economists such as Mr Kohn and Wall Street-aligned hedge fund professionals such as Ms Coronado, underlines the tricky balancing act Dr Yellen faces in lifting rates from near zero and communicating the Fed’s future plans.
Even though the Fed has been discussing the first hike for many months, interest rate traders are pricing in a less than one in three chance that borrowing costs will rise at the conclusion of its two-day interest rate meeting on Thursday.
Bond markets are betting that persistently subdued inflation and financial market turbulence flowing from China will cause Dr Yellen and her colleagues to err on the side of caution.
Australia is not immune from international economic events, though it appears less exposed to any market shock compared with emerging market economies more exposed to US dollar flows.
The Institute of International Finance estimates that investors have yanked up to $ US40 billion from emerging market portfolios since August 10, as much as 80 per cent of the magnitude observed during the 2013 “taper tantrum” when then Fed chairman Ben Bernanke hinted the $ US4 trillion bond buying program would be wound down.
‘Well telegraphed’
Reserve Bank of Australia governor Glenn Stevens said recently, the beginning of the Fed’s rate hike cycle had been “well telegraphed”.
Like Mr Kohn, the RBA governor believes the market interpretation of the Fed’s future path for interest rates is more important than the first move.
“Some turbulence may well occur as a result not of the first increase in US rates but of investors trying to assess how soon subsequent increases might occur,” Mr Stevens said in a July 22 speech.
“But sooner or later, we have to see a start to the process of adjusting these financial prices and I would expect Australian financial markets to be able to take all that in their stride.”
Dr Yellen has been at pains to emphasise in recent months that when the Fed does lift rates for the first time since June 2006, the path for future rate rises will be gradual and dependent on unfolding economic data such as economic growth, jobs and inflation.
Interest rate projections
The bond market is pricing in only one 0.25 of percentage point hike this year and about two further rate increases in 2016.
The FOMC is this week expected to downgrade its projections for future interest rates in the coming years, helping to smooth nervous markets.
The US economic recovery has been gathering steam, seven long years after the great recession pushed the jobless rate to 10 per cent.
Economic growth rebounded to an annual pace of 3.7 per cent in the June quarter, and the 5.1 per cent unemployment rate is in the range Fed officials deem to be around the non-accelerating rate of inflation.
Yet inflation has failed to rise towards the Fed’s 2 per cent target, weighed down by weak wages growth and plunging world commodity prices. China’s economic slowdown and 4 per cent yuan devaluation last month have raised the spectre of global deflation.
The Fed said in July, the deflationary pressures from lower energy prices were likely to be “transitory”, or in other words, temporary. It wants to be “reasonably confident” that inflation will push towards the 2 per cent target before lifting rates.
Economic theory
While textbook economic theory suggests a tightening labour market will cause wage pressures to creep in as employers compete for scarcer labour, to date there have been few signs of a rebound in inflation.
The dilemma is, as former top Fed economist Jon Faust explains, the recent economic data tells us “very little” about where the economy will be in one to three years from now.
“At some point as the labour market tightens, it will provide upward pressure on inflation and we will see inflation emerge,” he said. “Almost everybody believes we are getting near that point.”
Mr Faust said if the Fed did raise rates, monetary policy would still be “extraordinarily accommodative” at between 0.25 and 0.50 of a percentage point.
Another negative factor weighing on the minds of Fed officials is the recent ructions in China, including a sharemarket swoon and slowdown in the world’s second-largest economy.
While US trade exposures to China are only about 1 per cent of American GDP, wobbles in China’s economy and sharemarket have sparked turbulence in international financial markets.
A 10 per cent correction
US stock indexes suffered a 10 per cent correction late last month, as jittery investors on Wall Street ditched stocks in response to plunging equities in Shanghai and fears the stumbling Chinese economy may drag the world economy into a recession.
International investors seeking safety piled into US dollar assets, pushing up the greenback and restraining US exports.
Goldman Sachs calculates that since early August, US financial conditions have tightened by about 0.50 of a percentage point, due to the rising US dollar, lower stock prices and more expensive credit for companies. It helps explain why Goldman chief economist Jan Hatzius is tipping the Fed will delay a rate rise to December.
Mr Faust, now an economics professor at Johns Hopkins University, said the Fed would try to look through the international financial volatility to determine whether it would prevent inflation rising to the 2 per cent target.
“Does the volatility signal something about the underlying economy or is it like a lot of volatility in financial markets, a kind that will ultimately leave no trace in the data?”
Odds of rise ’50-50′
Capital Economics chief US economist Paul Ashworth believes the odds of a September rate hike are “50-50″.
“The cumulative improvement in the economy over the past few years means that it is almost impossible to justify interest rates still being at near-zero,” he said. “Nevertheless, a number of Fed officials clearly want to use the recent volatility in financial markets as a reason to delay the first rate hike yet again.”
Mr Kohn, a 40-year Fed veteran and now a senior fellow at the Brookings Institution, said regardless of the precise lift-off timing, rates would soon need to rise.
“Monetary policy works with a lag and will have very little effect on employment or inflation over the next three, six, nine months.
“Interest rates have to increase before too long.”
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