Federal Reserve Board chairwoman Janet Yellen addresses a congressional committee last month.Source: AFP
WHEN the Federal Reserve board’s open market committee meets later this week, it could mark another of those significant milestones on the path towards normalisation of US monetary policy settings. It might also ignite another bout of turmoil in global currency and bond markets.
The Fed isn’t going to announce the first rise in US official interest rates for nearly a decade after this week’s meeting. The most bullish expectation is that it might change the language associated with its perceived path towards that moment.
Where the Fed has been saying it would be “patient” in beginning to normalise its monetary policy stance, there is an expectation that it will drop “patient” from its lexicon, signalling that the start of the new phase in US monetary policy is nearing. The market believes that the first increase in US rates could occur in June.
The combination of the expectation that US monetary policy settings will start to be unwound this year and the quantitative easing policies of Japan (and more recently, the eurozone) have added a new layer of complication to the Fed’s deliberations.
The US dollar has been surging, nearing parity with the euro, and impacting the competitiveness of US exporters. The US dollar has risen 16 per cent against the euro in the past three months and about 25 per cent over the past year.
The combination of the stronger dollar and the collapse in the oil price means inflation isn’t a near-term issue for the Fed. It will have to weigh the impact on US competitiveness against the boost to consumers provided by the stronger dollar and the lower oil prices.
The speculation about the Fed’s intent has added to the volatility in currency and other financial markets generated by the quantitative easing and looser monetary policies adopted by much of the rest of the world.
More than 20 countries have cut their official interest rates over the past year, some to negative levels, to try to offset the impact of the competitive devaluations driven by quantitative easing in Japan and Europe.
When coupled with the rising US dollar, that has added to the volatility in capital flows and currencies. Last week, for instance, the Australian dollar fluctuated between a high of US77.40c and a low of US75.61c.
If the Fed signals a rate rise is looming in the next few months, one would expect the pressure on the Australian dollar to intensify.
The Reserve Bank’s desire for a lower dollar — something around or below US75c — is increasingly likely to be met, and probably overshot. With most of our major trading partners pursuing low interest rate and weaker currency strategies, depreciation against the US dollar doesn’t necessarily rule out further RBA cuts to a cash rate that is already at a historic low.
The expectations around US monetary policy are self-fuelling, attracting flows of capital into the US that keep US market interest rates low despite the likelihood of rising official rates and which push up the US dollar and other currencies down. Capital is flowing out of developing economies towards the US, which could create some unforeseen shocks.
The divergence between US and eurozone settings is transforming the euro into the new currency for carry trades and hot money, while helping to generate some much-needed positive impacts on the region’s competitiveness and activity levels. The normalisation of US settings might be within sight; those of the eurozone, however, are likely to remain unconventional for a long time yet.
Even if the Fed does provide a signal that normalisation of monetary policy will begin shortly, no one expects the path of that process to be rapid.
It will probably take several years or more, with lots of pauses in the process to take stock not just of the health of the underlying real economy, but of the policy settings of the rest of the developed world. The strength of the dollar in the face of the competitive devaluations occurring elsewhere may be a major input to policy.
The divergence already occurring between the US settings and those of the other key developed economies — which would be exacerbated if the Fed does start raising rates — adds uncertainty to an already uncertain environment. It probably ensures that the volatility in capital flows and financial markets that has been a major feature of the post-financial crisis environment will remain a constant for quite some time yet.