Not If, But How Fast And High The Fed Will Hike

By Lee Boon Keng

 

As expected, the Federal Reserve did not raise its policy rate at its October meeting. The top two reasons for why the Fed is not rushing to hike rates are the volatility in emerging markets and the absence of headline inflation in the United States.

To be sure, the current malaise afflicting emerging markets, including China's, is not new. It started with the "taper tantrum" in mid-2013 when the Fed raised the prospect of reducing quantitative easing. Since then, commodity prices have tumbled and took with it any growth momentum in emerging markets. Between then and now, the US economy has continued to improve, most notably in the labor market where unemployment rate has fallen from 7.5% in mid-2013 to 5.1% in September 2015.

More importantly, history has shown the US economy to be relatively resilient to economic crisis in emerging markets. The Asian Financial Crisis (AFC) in 1997/98 is a case in point. While countries in East Asia were suffering from the consequence of a borrowing binge, the US was building up the NASDAQ bubble that burst in 2000 that was totally unrelated to the AFC.

Hence, the market's call for the Fed to stand pat because emerging markets are unstable could just be an excuse to keep the punch bowl flowing, as evident from how emerging markets tend to rally every time the Fed delays its lift-off.

As for the absence of headline inflation, the culprit is quite obvious – persistently low oil price. However, excluding food and energy, commonly known as core inflation, prices have risen by 1.9% year-on-year in September 2015, just shy of the Fed's 2% target for headline inflation. That is, while the Fed is not seeing its inflation target reached on the headline level, it is materializing on the core front. This is because low oil prices increases the level of disposal income and together with improving labor market conditions, we can expect confidence and spending to remain relatively robust.

The fact of the matter is that besides the above two rather unconvincing reasons, most economic indicators are suggesting that the Fed is behind the curve in raising interest rate.

So why is the Fed so reluctant to begin the process of normalizing its monetary policy? The answer could lie in the current make-up of the Federal Open Market Committee (FOCM).

This year, we have a dovish FOMC much like in 2013 where the Fed was equally reluctant to start tapering. Its confusing messaging then too created a great deal of uncertainty in the market, albeit not as volatile as this year where an actual tightening is on the cards. As in 2013, there is only one hawk among the FOMC voting members this year – Jeffrey Lacker, President of the Richmond Federal Reserve. (In 2013, Esther George from Kansas City was the only hawk.)

The Fed finally started to reduce the amount of quantitative easing (QE) in December 2013. Much to the surprise of the market, however, it reduced the amount in every meeting in the following year until QE was finally concluded in October 2014.

Why was the Fed so steadfast in its tapering in 2014? Were economic indicators consistently good? No. Were emerging markets stable? No. Was inflation climbing above 2%? No.

Was the composition of the voting FOMC more hawkish? Yes.

In 2014, there were two "super" hawks voting in the FOMC – Richard Fisher from Dallas and Charles Plosser from Philadelphia – plus Loretta Mester from Cleveland who took on the role after having worked in Philadelphia Fed since 1985. Hence, there were three hawks voting on monetary policy in 2014, resulting in an unexpectedly swift end to QE.

If the experience in 2014 were anything to go by, then the questions that the market should be asking are firstly, what is the make-up of the FOMC in 2016, and secondly, how fast and high will the Fed raise interest rate to?

In 2016, as in 2014, the FOMC will have more hawks voting compared to the previous year. They are: Esther George from Kansas City, Loretta Mester from Philadelphia and the newly converted James Bullard from Saint Louis. Additionally, Stanley Fischer, the centrist Governor has lately sounded less dovish than before.

So, hawkish voices will be louder in the 2016 FOMC. If they manage to get their way, then we can expect a steady and dogged determination to normalize monetary policy through the year.

What does the Fed considered as the "normal" rate of interest for the US economy? This can be gleaned from the Projection Materials published by the Fed, four times a year after its FOMC meeting.

In the report, Fed officials are asked to provide their long-term projection of the Fed's policy rate. From the time this information has been available in 2012, the Fed's long-term projection of its policy rate has averaged between 3.5% and 4%.

Does a Fed funds target rate of nearly 4% make any sense, especially when we have been at near zero for the past 6 years? Yes, if you can accept the long-term average real Fed funds target rate as a good proxy of the appropriate level of monetary policy.

The real Fed funds rate is the actual (nominal) Fed funds rate minus the rate of inflation. That is, it measures the level of interest rate after having accounted for its impact on inflation. Hence, for a given long-term average economic growth rate, there would be a corresponding average rate of inflation that can be attributed to an average policy rate.

Data shows that the 30-year average real Fed funds target rate is 2%. Since the Fed has an inflation target of 2%, then history says that the appropriate policy rate to reach that target ought to be 4%! It is therefore no wonder that the Fed has maintained a long-term Fed funds target rate of around 4% over the current cycle.

Unless you believe that the US is the next Japan in the making, the Fed will not be staying at the zero bound for much longer. We know that the 2016 FOMC will be decidedly more hawkish than the 2015 cohort. This means that, as in 2014, the pace of tightening is likely to be faster towards its long-term target of 4%.

I don't think emerging markets are well-prepared for that!

About the author

Lee Boon Keng is Associate Professor of Banking & Finance, and the Director of Centre for Applied Financial Education (CAFE), Nanyang Business School, NTU.