Against the tide: Don’t be surprised by a Fed rate rise
Market expectations of interest rate stability fly in the face of growing signs of inflationary pressure and the likelihood of a move by the Federal Reserve.
The consensus in financial markets is that this year the Federal Reserve will hold interest rates at present levels or even cut them. My own view, though, is that the Fed’s next move will be up. The liquidity-driven asset boom in the US is reviving inflation and the Fed will have to act.
Other central banks will also raise interest rates. After Japan’s upper house elections are out of the way in the summer, the Bank of Japan will tighten – it might even act before then. The European Central Bank has more work to do, with eurozone credit growing at double-digit rates. And the Bank of England is already in hawkish mode.
So global policy interest rates will move up in 2007. And rising inflation and short-term interest rates will push up long-term bond yields.
Since the Fed last raised its policy interest rate in June 2006, US financial markets have risen on the back of expectations that the next move will be to cut rates. However, since the New Year investors have become less confident that the Fed will cut, and equity and bond markets have marked time.
The Bank of England has already made a surprise rate increase in 2007 as UK inflation nearly reached the bank’s 3% target limit. In continental Europe, the ECB will raise the refi rate next month. Eurozone inflation is close to its target ceiling and previous tightening has not slowed credit growth sufficiently. German unions are pressing for higher wages. Some key sectors are calling for a 5% pay increase. They are likely to get no more than 2% in 2007, but that’s double the rate of 2006.
Political pressure has prevented the Bank of Japan from tightening up to now. Tokyo politicians are concerned about an electoral backlash because of rising interest rates in the upper house elections this summer. The central bank would rather appease its paymasters than preserve what seems to be nominal independence. However, once the elections are out of the way and Japanese economic growth consolidates, the bank will be free to tighten again.
US inflation has got a second wind, rising from its low of 1.3% year on year in October to 2.5% year on year in December. And the Fed’s preferred measure of underlying inflation – the core personal consumption expenditure deflator – remains uncomfortably above its unofficial 2% year-on-year target ceiling.
There are now signs that the US housing market has bottomed out. Existing home inventories have started to fall. Manhattan apartment prices rose in the Christmas quarter, driven by big Wall Street and real estate bonuses/commissions. The National Association of Home Builders index has been gradually recovering since September. Housing starts in December rose 11% from a low in October.
The consensus expects the US economy to grow by about 2.5% in 2007. That would be slightly below potential long-term output growth and so would not increase inflationary pressure. However, US economic growth currently looks stronger than that. If it just matches last year’s 3.5% rate, it will exceed by 0.7 percentage points the long-term potential GDP growth rate and inflationary pressures will return.
There are anecdotal signs that resource tightening is already under way. The latest Fed Beige Book warned of tightening labour market conditions and of "some businesses having difficulty finding qualified workers".
The trend in wages is up. Average hourly wages taken from the monthly payroll reports have accelerated sharply over the past two years. The most comprehensive measure of US wage inflation is the Employment Cost Index. It has stabilized at around a 3% annual clip, mainly because of a slowdown in the growth of non-wage benefits. But the wages and salaries component of the ECI has accelerated from 2.3% year on year in Q3 of 2005 to 3.2% year on year in Q3 of 2006.
If the housing market starts to recover, inflation could start to rise, as it has done in the UK. Ben Bernanke is coming up to his first anniversary as Fed chairman. He won’t want a reputation for being weak on inflation for the rest of his term. Unfortunately for him, despite a rise in policy rates, long-term interest rates have risen only 40 basis points and the US dollar has depreciated against the major currencies over the past year or so. So monetary conditions are not especially tight.
So I reckon that, as inflation accelerates, the Fed will surprise financial markets and return to another phase of raising interest rates. This time it could cause the long end of the yield curve to rise too. Then liquidity in the derivatives market would evaporate, forcing up the global cost of capital. That’s not good news for liquidity-driven financial markets.
David Roche is president of Independent Strategy Ltd, a London-based research firm. www.instrategy.com