We may live in a global economy, the forces of which so often seem beyond human control, certainly beyond national politicians’ control. But just sometimes a financial decision by a group of people in one country will send a shockwave around the world, and we are about to witness that this week.
The headquarters of the US Federal Reserve System is a huge, white, neoclassical temple on Constitution Avenue in Washington DC. The members of its Open Market Committee, chaired by the economist Janet Yellen, gather today for one of their regular two-day meetings to decide on monetary policy – and in particular, on whether to increase interest rates. Their decision will be announced on Thursday.
There are eight such meetings a year. Were it not for one fact, this would be another regular event on the Fed’s calendar, interesting and important for anyone involved in financial markets but not of great significance to the rest of the world. But that fact is that the Fed has not increased interest rates for nearly a decade – and this may well be the time it does.
Central bankers, even those at the central bank of the world’s largest economy, are not all powerful. The decisions they take adjust the cost of funds available to the banking system – and with quantitative easing, the scale of the funds pumped into the banking system. But they have to respond to the needs of the economy, essentially making judgements as to whether to pump things up or damp them down. And they don’t always get those judgements right.
With hindsight, they should have leant harder against the long boom that ran to 2008, clamping down earlier on the ability of banks to spray money around the world. Those central banks that were more cautious, such as the Bank of Canada, helped shave off the excesses of the boom, and consequently the scale of the crash that followed. It does not absolve the commercial banks for massive errors of judgement, and worse, to say that neither the Federal Reserve nor the Bank of England is free from blame during the years of excess.
When the crash came, most central banks in the developed world dropped interest rates to the floor, and when that failed to revive economies, bought in government debt, thereby pumping money (in exchange for that debt) into the banking system. That did work, and those programmes have now largely ended. What has not ended is the policy of near-zero interest rates; that may finally end on Thursday.
What the Fed does affects the whole of the world. It is not just the size of the US economy, or the importance of US banks, or even the global role of the dollar that matters. It is intellectual leadership that the Fed brings.
The Fed will be an icebreaker, clearing the way for the convoy of lesser ships to chug along behind. When US rates rise, others follow. The Bank of England will follow either later this year or early next, because the UK economic situation is broadly similar to that of the US. Eventually even the ECB will have to follow too, despite having to set a single interest rate for a very diverse group of nations. Eventually, the Bank of Japan will have to shift too.
So what will the Fed do? The arguments are evenly balanced, as indeed are the odds as gauged by the money markets. It has two main considerations and one main constraint. One consideration is inflation; the other unemployment. There is no explicit inflation target, as there is here or in Europe, but it sees a 2 per cent rate as “most consistent over the longer run with the Federal Reserve’s mandate for price stability and maximum employment”. There is no explicit maximum employment rate either, but an unemployment level of around 5 per cent is seen as full employment.
The headline US consumer inflation in July (we don’t yet have August figures) was only 0.2 per cent, but the underlying inflation, which excludes volatile food and energy prices, was 1.8 per cent. Economists expect both measures to rise above 2 per cent early next year. So on inflation grounds, notwithstanding the low current inflation, the Fed would probably move. As for unemployment, that is down to 5.1 per cent, a level that would also be consistent with an increase. The signals are green to go.
2008 Financial Market Crash
2008 Financial Market Crash
1/6 14 trillion dollars
That’s how much the global financial crisis cost the US economy – equivalent to a full year’s GDP, according to a 2013 study by the Dallas Federal Reserve.
2/6 12 billion pounds
The deal that Lloyds TSB announced in September 2008 to take over Britain's biggest mortgage lender HBOS
3/6 323 billion euros
Greece's total debt, seven years after the financial crisis exposed its hidden borrowings and government overspending
4/6 27 per cent
The peak unemployment rate Spain hit in early 2013. It was around 8% in mid-2007
5/6 12 Billion Pounds
The amount in pounds that RBS reported as losses in February 2009, the biggest in British corporate history.
6/6 70 years
Since we had another recovery this slow - and that was after the Second World War
The constraint, the flashing amber light, is the international situation: the slowdown in China and the impact that is having on the whole of South East Asia and on commodity exporters more generally. These concerns have transmitted through the markets.
The job of the Fed is to do what is right for the US, not the rest of the world, but insofar as the rest of the world does affect America, then it should take note. The danger is that were the Fed to move too early, it would add to the sense of concern, even fear, that undoubtedly exists in financial markets. There is nothing wrong with investors being a bit fearful, indeed that is a sign of healthy markets for over-confidence precedes disaster, as we have seen. But you don’t want them truly terrified, because if they freeze up, that knocks the economic expansion, which viewed globally is struggling a bit.
If on the other hand the Fed is thought to be moving too late, that both increases uncertainly about its future actions, and risks much sharper (and more damaging) increases in rates in the future.
My own view is that it would be safer for the Fed to move now. William McChesney Martin, chair of the Fed from 1951 to 1970, famously said the job of the Fed was “to take away the punch bowl just as the party gets going”. As anyone who has spent time in the States this year will acknowledge, it may not be the greatest of parties, but I don’t think it needs free booze to keep going.Reuse content