international analysis and commentary

“All Rise!”: assessing the Fed’s moves


On December 16, the United States Federal Reserve (Fed) raised interest rates for the first time in nine years, a move some fear will cause major negative effects, while others believe was long overdue. In her statement announcing the decision, Chair Janet Yellen explained that, given the economic outlook, the Fed lifted the federal funds rate from 0.25 to 0.50%, “thereby supporting further improvement in labor market conditions and a return to 2% inflation”. With this, the Fed became the first major Western central bank to raise its key rate since the credit crisis. Nevertheless, there is still a long way to travel to get back to a “normal” level of say 3 or 4%.

Meanwhile in Europe, rates are still at a historical low. Less than two weeks ago, the European Central Bank (ECB) decided to keep its main rate at 0.05%, and to bring its already negative rate on commercial banks deposits even further below zero (to -0,30%). It also pledged to continue its €60bn-a-month bond buying program for six months longer than originally tabled, until at least March 2017.

It seems as if monetary policy in the US and Europe is now beginning to diverge after a long period of convergence. After the financial crisis hit in 2008, central banks on both sides of the Atlantic took extraordinary measures to boost their respective economies. In the months following the Lehman Brothers collapse, key interest rates were lowered (close) to zero. Furthermore, the ECB and the Fed developed substantial quantitive-easing programs (QE) to provide extra liquidity to the markets. These measures were taken in an attempt to create a way out of the credit crunch for the financial sector and, as a consequence, for the real economy. Naturally, unconventional monetary policy of this sort is always followed with great curiosity and anxiety. Many people feared that these programs would eventually lead to out-of-control inflation. Others warned of a cheap credit bubble that could lead to new instability and possibly a new credit crisis.

None of these scenarios occurred, yet. But the irony is that we might start feeling the impact of the ECB and Fed actions now, when rates move up again after years of close-to-free central bank money.

In fact, the Fed’s decision (which might be followed by additional hikes in 2016) could have measurable effects far beyond the US. They might be visible first of all in the real economy. The relative value of the dollar against the euro is likely to increase, which could spur exports from EU countries to the US. An increase in the value of the dollar might also put further pressure on the price of oil, which is already at a historical low. Generally, when the value of a currency increases, prices will decrease.

The impact on financial markets might be even more substantial. Although the stock market climbed immediately after Yellen’s statement, an interest rate increase usually drives stocks and bonds down. This is to say, when the cost of money goes up, both stock prices and trade volumes are negatively affected sooner or later.

A group of analysts feared the Fed’s decision would cause a “credit event”. Some market participants, these analysts argued, were leveraged (meaning indebted) to such levels that even just a 0.25% rate rise would make it no longer possible for them to meet their margin calls and collateral obligations. Such an event did not occur; neither I expect it to happen in the weeks to come. The markets have been anticipating the Fed’s move for quite some time now, and as a result a rate increase of 0.25% had been priced in in all major asset classes before it even happened. However, even though these so called “doom thinkers” have been proven wrong today, a credit event remains a possibility in economies that still heavily depend on cheap and easy-to-access money, which is the case for almost countries in the Eurozone where economic growth is still weak. Therefore, going forward the way central banks communicate might be even more important these days than the actual decisions they make.

Last, we come to the issue of the Eurozone-US monetary policy divergence. Since the crisis, the Fed and the ECB have been closely watching each other’s decisions. However, at the end of the day these two institutions operate each in its own context. For the past three years, the US economy has been performing much better that the Eurozone’s. Therefore, the Fed’s rate hike is not only sensible but also in line with the role it is primarily expected to play. On the other hand, the Eurozone as a whole shows little sign of recovery. Some Member States may perform slightly better than others, but overall real economic growth has been absent since the crisis, and there is little reason to believe that it will return to more robust levels in the foreseeable future. An additional problem for the ECB is the worrisome state of public finances of some Eurozone members.  Hence its recent decision to extend its bond buying program, to keep up (indirect) support for countries that, since 2010, have been struggling to access the international credit market. Given the fact that Europe has not found any real solutions to its debt crisis, it is unlikely that the ECB will end its QE program and lift interest rates any time soon.

The effects of such dis-alignment will spill over. The Eurozone is one of the most important trading partners for the US. The lesser interest rates align, the greater the difference in currency value, which will further affect the US-EU trade balance.

In general, the limited increase of the Fed’s key interest rate we have seen in December might cause some tremors in the markets, but on its own is unlikely to have substantial long-term effects. For this, a series of rate rises is needed. In her statement, Chair Janet Yellen hinted that these were possible over the course of 2016. My expectation is that there will only be one or two at best. Central bankers are like the captain of an oil tanker. They think fast to move slowly.