With as many as six Federal Reserve (Fed) officials expecting only one interest rate hike this year – as opposed to just one official previously – a sense of unease emerged from the latest Fed meeting on 15 June.
Keeping the US central bank on its toes is the risk of the UK leaving the European Union, with a vote for ‘Brexit’ on 23 June. At the recent meeting, Fed Chair Janet Yellen was particularly worried about potential financial-market disruptions that could spread to US markets, and therefore the US economy. This comes as recent opinion polls have shown the ‘Leave’ camp making some headway versus ‘Remain’.
The Fed is far from lowering its guard
While the global macro backdrop – as well as financial markets – seems to have improved or calmed in recent months, the Fed is far from lowering its guard. It even warned that investor perceptions can shift abruptly, a veiled warning against complacency. The problem with such bearishness is that it could become self-fulfilling.
Strength of US recovery in doubt
The biggest surprise at last week’s meeting was the growing doubt about the strength of the US recovery. Weaker employment data, combined with ongoing disappointment in corporate investment, has undermined many members’ view that the US economy could decouple from the global economy.
Fed members also seem to be coming round to the view that US productivity growth may be stuck in low gear. The ‘secular stagnation’ theory, brushed aside in the past, is now permeating Fed thinking. Yellen warned about a potential ’new normal’ for the neutral rate, the Fed’s key benchmark against which it compares current monetary policy conditions.
Not only did Yellen bluntly admit her disappointment that the real neutral rate was stuck at zero, she also surprised by warning that it may remain low. Implicitly, this means the Fed expects few growth-enhancing measures from the next administration. Yellen cited unfavourable demographics, slow household formation, and poor productivity growth. This is a sharp reversal of the previous view, or hope, that the neutral rate would pick up, which she asserted when hiking rates in December.
High bar for hiking rates
Looking ahead, the Fed seems to be setting a high bar for hiking rates again, even though Yellen, almost reluctantly, said another rate hike was ’not impossible’. Still, gone are the arguments which accompanied the first rate hike in December, such as the need to be ’pre-emptive’ about future inflation risks, or the fact tightening is a ‘sign of confidence’ in the US economy.
We think the next step may be more easing rather than tightening
There are signs that the US business cycle is now in its late-cycle stage, and underlying growth may lose momentum. We remain particularly worried about construction and car sales, which could slow in the second half of the year, affecting US growth. US oil production is likely to continue to drop, affecting the manufacturing ecosystem. As a result, we continue to think the Fed is unlikely to hike rates in coming months.
In fact, we still think the next step may be more easing rather than tightening. This could happen by year-end, when recession risks may grow, although ultimately it will depend on when hard data, particularly jobs and business surveys, starts to wane. Core personal consumption expenditure (PCE) inflation, a key benchmark, is unlikely to be a threat, in our view. But decelerating rents may start to pull down inflation, slowing the pace of core inflation down, which could further persuade the Fed to do a U-turn.
Another consequence of the Fed’s prudent stance is that there is now a growing risk the Fed’s quantitative easing (QE) programme could become semi-permanent. The Fed, which has a USD 4.5 trillion balance sheet, continues to reinvest maturing bonds from its previous quantitative easing (QE) programmes, waiting for rate hikes to be ’well under way’ before ceasing reinvestment.
The question is whether this point is likely to be reached anytime soon – it may not. We may have to accept the Fed’s balance sheet remaining large for longer. More QE cannot be excluded if a sizeable shock hits the US economy down the road. This time around, however, there could be questions about whether this will be enough to lift the economy out of its torpor.