The waiting game

After the Federal Reserve policy meeting last week the world is still waiting for the first US rate hike in nine years, or as most central bankers would prefer it put, a move by the Fed to a slightly less growth accommodative policy stance. How the rate hike is interpreted when it arrives eventually is a significant issue and is probably the main reason why it has not occurred already.

The way the Fed wants the first hike interpreted is as a marker of confidence that the US economic recovery is entrenched and inflation is rising to where the Fed wants it to be, a sign that the US economy no longer needs extremely accommodative monetary policy. Financial markets, however, seem unlikely to take quite such a benign view of the first Fed rate hike raising a range of concerns including the path and pattern of further rate hikes beyond the first one, potential funding concerns for US dollar denominated emerging market debt and impact on foreign exchange rates.

Some of these concerns will be very hard to alleviate. As RBA Governor Glenn Stevens put it speaking to the House of Representatives Economics Committee last week, the uncertainty surrounding Fed rate hikes beyond the first one is “irreducible” depending as Stevens said as they should on how US economic readings evolve.

While it seems likely that financial market volatility will still feature well beyond the first Fed rate hike, the waiting game before the first Fed rate hike also seems unlikely to be the patient waiting game the Fed would prefer and seemed to ask for in Fed Chair Yellen’s press conference after the policy meeting last week. In basic terms the Fed said that it still saw US economic conditions progressing to the point of permitting a first rate hike in the near future, but that that the impact of a slowing China and the recent turmoil in financial markets required the Fed to wait a little.

At the same time the Fed lowered slightly its US GDP forecasts for 2016, 2.2% to 2.6% range from 2.4% to 2.7% forecast in June and for 2017 to 2.0% to 2.4% from 2.1% to 2.5%. Longer term GDP forecasts were also lowered to average 1.8% to 2.2% range from 2.0% to 2.3%. In short the Fed was saying that the US growth outlook beyond 2015 is bleaker than forecast back in June, that there are international influences with potential downside impact on the US growth outlook that need watching, but although these developments meant no rate hike this meeting one is still coming in the near term.

There are contradictions in what the Fed is saying about the US economic outlook and the outlook for rates. As a result, financial markets are likely to develop varying views about the rate outlook, a source of further volatility. In our view, the waiting game before the first rate hike is unlikely to be the patient waiting game in global financial markets that the Fed would like.

Other central bankers around the world are showing signs of becoming impatient with the Fed too. RBA Governor Glenn Stevens has gone as far as saying that getting going the process of reducing rate accommodation would be good for the US in that the US recovery has progressed to the point that very accommodating monetary policy is no longer necessary. A stronger sign from the Fed that the US recovery is entrenched would also serve better the RBA’s quite upbeat assessment of Australian economic prospects and reduce pressure on the RBA to cut Australia’s 2.00% cash rate any further.

The RBA has been building a case for some months that the 2.00% cash rate strikes just the right balance between sufficient accommodation to support economic growth in the face of the once in a century downturn in mining investment spending while not creating a bubble in particularly interest-rate sensitive parts of the economy such as housing. Another part of the RBA’s case is a sort of law of diminishing return from the use of rate cuts at low interest rate levels.

The problem the RBA faces is that the Fed’s caution to lift rates speaks of a global economy that may be losing more growth momentum than is allowed in the RBA’s economic forecasts. The seemingly protracted period of financial market instability that lies ahead as the Fed delays may make the global economic outlook even worse. Over the next few months, the RBA’s upbeat economic outlook may become increasingly hard to sustain. The RBA is playing its own waiting game with the cash rate on protracted hold, but time may be starting to run out as economic indicators overseas and possibly in Australia too take a weaker a weaker turn.