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Bassanese: The Flipside Of A Dovish Fed

Despite steady improvement in the United States economy, Fed officials and market analysts still talk of the first official US interest rate hike not taking place until “sometime next year.”

Sadly, I don’t see this outlook changing anytime soon, which is good news for those chasing risk markets over the nearer-term, but poses risks to the longer-run health of the global financial system.

In an important speech tonight, US Fed chairperson Janet Yellen is widely expected to repeat her mantra that interest rates are likely to remain on hold for some time.

Specifically, the Fed’s current guidance is that it’s likely to keep interest rate steady “for a considerable time after” its asset purchase program ends. Given this - and the fact the Fed’s bond buying program is currently scheduled to end later this year – has led markets to quite reasonably expect no interest rates hike until at least mid-2015.

As a result, investors have no choice but to remain agile – enjoy the good times while the last, but be alert to a bottling up of troubles that will likely explode later.

For the moment, investors should be enjoying the fact that the US economy remains in a “sweet spot” - or the early stages of an upturn in which economic growth improves, yet there’s still enough lingering spare capacity to keep inflation and interest rates relatively low.

Investors should also be enjoying the fact that Federal Reserve chairperson Janet Yellen is so far living up to her dovish reputation, and has steadfastly refused to hint at an early interest rate increase despite clear improvements in the economy.

But to my mind, the Fed has already slipped badly behind the curve, and should have started raising interest rates as long as year ago. That’s not because US consumer price inflation is taking off - I strongly doubt it will - but rather because persistently low interest rates are slowly but surely distorting a broad range of financial asset prices, which increases the risk of sharper and more destabilising correction later.

In many markets, risk premiums are already approaching the lows prior to the 2007-2008 global financial crisis. The “search for yield” has returned with vigour.

And while the Fed’s very considerate forward guidance policy - including promises to keep rates steady for an extended period and duly warn players well ahead of time when it intends raising interest rates – has contributed to market stability, it has also arguably help produce the very low levels of volatility evident in many markets, which has allowed high leveraged “carry trades” to thrive.

There appear many crowded trades across global markets at present, including the purchase of the $A for its yield pick-up, not to mention higher risk corporate bonds.

Had the Fed moved earlier, it would have resulted in more measured stock market gains to be sure - but it would have also allowed the US economy and global financial markets to more gradually adjust to a more realistic interest rate environment.

The Fed seems not to have learnt any of the lessons from the extended period of easy monetary conditions which sowed the seeds for last great financial market crash.

Why the Fed has not acted sooner is hard to fathom. After all, the US unemployment has been steadily falling since late-2009 and is now even lower than in Australia at only 6.2 per cent. Of course, US labour force participation remains depressed by the lingering soft state of the labour market, so America’s unemployment rate decline probably overstates the degree of economic improvement. But that’s also true in Australia.

Yellen herself has recently suggested that continued low US wage growth is a reason to forestall the inevitable increase in interest rates – which is surprising given that wages are very much a lagging indicator of the economy. Surely when interest rates are at “emergency” levels of near-zero, the Fed needs to be a little more pre-emptive.

I suspect the Fed has caught itself in a bind, given it has been goaded into providing a specific timetable over when it will act – which is now hard to adjust even in the face of improving economic data.

Yet as recently noted by San Francisco Fed President John Williams “we need to be responsive to the data, not to some calendar or point in time,” he explained. Amen to that.

Whether the Fed has the guts to admit conditions have changed and it should bring forward interest rates increases remains to be seen. I doubt it – which leaves me optimistic over the short-term on risk markets, but very nervous about the outlook in one to two years time. Keep picking up the pennies, but be wary of the steamroller ahead.

View More Articles By David Bassanese

David is one of Australia's leading economic and financial market analysts. His is Chief Economist with BetaShares, and an Economic Advisor to the National Institute for Economic and Industry Research (NIEIR). His has held former roles as senior commentator with The Australian Financial Review, Macquarie Bank interest rate strategist and Federal Treasury economist. He is also author of the online e-book, TheAustralian ETF Guide.



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