Be Skeptical of the Fed's Rate Signals
At its last policy meeting, in December, the Federal Reserve decided to increase the federal funds rate by 25 basis points. It also indicated that it expected to increase interest rates three times in 2017, as Chair Janet Yellen painted a rosy picture of the prospects for the U.S. economy that pushed up Treasury yields and hit emerging market equities and currencies hard. Minutes of the meeting released Jan. 4 reiterated the Fed’s expectation of faster economic growth this year.
Yet the reaction of markets may have been premature: The Fed's outlook deserves to be treated with a big dose of skepticism, particularly given the central bank's record in recent years. The Fed has largely gotten it wrong since 2009, as it repeatedly forecast a rapid pickup of the U.S. economy that would be accompanied by several rate increases. In fact, it has raised the federal funds rate by only two baby steps since the 2008 financial crisis, and there's little reason to believe it has now regained credibility.
A critical error in the Fed’s reaction has been the low importance bank officials have accorded to global developments that have required them to revise forecasts. The threat of a Greek default in 2010, and Italy’s debt crisis and political turmoil as Prime Minister Silvio Berlusconi resigned in 2011, along with the Chinese market tumult last January after the Fed hiked in December 2015, were just a few of the international developments that forced the Fed to change course.
The Fed’s aggressive posture is not supported by international finance theory, either. The U.S. cannot hike rates while central banks elsewhere maintain near-zero or negative rates, unless the U.S. is willing to accept a sharply appreciated dollar, which President-elect Donald Trump has made very clear he wouldn't abide.
Look at it another way: According to calculations by the European Central Bank, 529 billion euros ($560 billion) in capital left the single-currency area over the 12 months that ended in September 2016. This was the largest outflow since the euro came into existence in January 1999. Much higher U.S. rates this year will exacerbate the cash exodus from Europe, further delay the region’s recovery and hurt U.S. exports, especially with a stronger dollar.
In addition, emerging-market countries account for more than 50 percent of the world's gross domestic product and their markets and currencies have also been hit by the hawkish Fed message and by Trump’s victory in the U.S. presidential election. These countries are highly dependent on exports to maintain growth at a pace faster than that of developed economies, and the Trump pledge of new trade restrictions has already put on the defensive many emerging-market central banks and finance ministries.
It’s too early to assess the net impact of Trump’s economic policies, the World Bank said last week in the latest update to its global economic outlook. It left its forecast for U.S. growth this year and next unchanged, at 2.2 percent and 2.1 percent.
Nonetheless, the adverse impact is most apparent in China, the world’s second-largest economy and a major market for U.S. exports. Higher U.S. rates have sparked capital outflows -- as they did in late 2015 and early 2016 -- and the People’s Bank of China is taking tough administrative measures to limit the flight. As part of a liquidity squeeze to hurt yuan bears, the offshore yuan deposit rate was allowed to rise to a record 100 percent earlier this month, and the yuan actually appreciated in offshore (Hong Kong) trading. This can’t be sustained for too long, however, without having a significant impact on the pace of China's growth.
After meetings in China last month, I concluded that global market reaction to Yellen’s ebullient message makes it highly unlikely that the U.S. central bank will be able to raise rates three more times this year. The Fed’s record over the past 12 months - - projecting several rate increases that didn't come to pass -- provides the template for the coming year as well.
A slowing of the global economy and global trade because of China’s and Europe’s weaknesses may earn the Fed chair the moniker of “Once-a-Year Yellen” for the third consecutive year.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
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