Janet Yellen has become the heroine of Washington. Earlier this month she completed her first year as chair of the Federal Reserve board, a year in which, by general accord, she has been pitch-perfect in her management of monetary policy.
The Fed has ended its version of quantitative easing – the monthly purchases of Treasury securities – without disrupting the US economic recovery. Growth, at 2.4 per cent last year, has been faster than in any major economy bar the UK, and it is expected to top 3 per cent this year. Unemployment has fallen from 6.7 per cent to 5.6 per cent, with a million jobs created in the final three months of 2014. Yet inflation has remained a bit below 2 per cent, the Fed’s target. Looking ahead, helped of course by the fall in oil prices, it is expected to decline to between 1 per cent and 1.6 per cent this year – but not to go negative as has happened in much of Europe.
All this has pleased foreign exchanges, with the dollar up 10 per cent against a basket of currencies and 20 per cent against the euro. Yelland has even managed to please Wall Street. A year ago the S&P 500 share index was 1,820; on Friday it closed at 2,097.
Her second year looks tougher: this will be the year when US interest rates start to go up. We will get more of a hint as to the likely timing and profile of such increases when Yellen gives her twice-a-year Humphrey-Hawkins testimony to Congress in 10 days’ time. The markets, reading the runes of previous statements, are expecting the first increase around June, but with a gradual upward trend. That first rise will come just after the UK general election. Given our similarly rapid growth and falling unemployment, the US experience of increasing interest rates seems likely to become a template for the UK, just as its experience of QE did all those years ago.
It will, however, be tricky. The expectation of higher US rates has already driven the dollar up. Since there is zero prospect of any increase in eurozone interest rates for a couple of years, it looks likely to continue to do so against the euro, maybe also against sterling. For the time being this is not a huge issue. For the moment, the dollar is reasonably valued on its purchasing power parity. There are two sides to any exchange rate and it may be that Europe will manage to engineer enough of a recovery to generate demand for euros. The US economy will undoubtedly soon need higher interest rates, but you don’t want to undermine what is, so far, pretty much a success story.
That leads to perhaps the biggest question of all: why has America done so much better than Europe? The different monetary outlooks are a reflection of economic divergence. In bright – if blisteringly cold – Washington, the answer seems easy enough. The US fixed its banks more quickly, had looser fiscal and monetary policies, and had none of the internal tensions of the euro. Viewed from continental Europe this all seems monstrously unfair. The US, it is widely felt, created the great recession with its lax banking regulation, yet it has recovered much faster. You don’t have to travel far in Europe to appreciate that the UK also generates some of this hostility.
In Washington, though, what Europe thinks does not occupy much space of mind. Apple has become the most valuable company in the world, ever, by designing stuff in California and having it made in China. Europe is a big market, but a slow growing one. When Americans do think about Europe, they see it as a problem, not a place where you find solutions. Thus a number of US economists have felt able to criticise European economic policy, with Germany the main target for its supposedly over-conservative fiscal policy.
Will this American self-confidence, so evident to any visitor from Europe, peter out when, perhaps in a couple of years’ time, the economy starts to run into capacity constraints, rates go up maybe quite sharply, and the strong dollar starts to curb growth?
Well it may, but there are three reasons for optimism. One is that the US is set up to cope with a stronger dollar, making much of their stuff abroad. Consumption is 70 per cent of GDP, and consumers benefit from lower prices, whereas merchandise exports are only 13 per cent.
A second is the way in which US manufacturing is reviving on the back of cheap energy. The oil industry may now be in trouble and much attention is paid to America’s hi-tech champions, but the big winner from the plunge in energy prices has been manufacturing, which is now leading economic growth.
The third bit of good news is that there is a Fed chair who has earned great respect. And there is every reason to think that she will continue to earn respect in her second year.Reuse content