FYI | Jun 26 2008
By Greg Peel
Last night the Fed left its cash rate unchanged for the first time since September – a month in which the famous “shock and awe” 50 basis point rate cut was meant to end the credit crunch as quickly as it started. How naive that all seems now. But as we approach the first anniversary of the beginnings of the credit crunch – when Bear Stearns announced two of its funds were in trouble last July – one can only note that the global financial sector is in as bad a state as it has been over that year.
Which is why subsequent Fed rate cuts, including two of 75 basis points, have been necessary. The Fed rate is now at 2%, down from 5.25%. But despite there having been little relief on the financial front, and despite the US economy looking weak, The Fed decided last night to cut no further.
The reason is that the Fed rate cuts to date have only served to unleash the inflation beast. Yes – you can argue till you’re blue in the face about Chinese demand, but the parabolic moves in commodity prices recently have been as much about fears of a collapse in the US dollar as they have been about a Chinese yearning for cars and hamburgers. Fund managers have switched to direct commodity investment, and commodities are in a bubble.
Across the globe there are now fears of slowing economies. The US is teetering on recession, the UK has begun to slow, Europe looks like it might be about to slow, Australia has shown signs of slowing and New Zealand is heading for a full-blown recession. Under normal circumstances, bond markets across the globe would be factoring in interest rate cuts ahead, as that is how central banks usually deal with slowing economies. But if interest rate markets are correct in their current assumptions (as indicated by forward yields) then in one year’s time rates in the US will be 1.25% higher, in Europe 0.75% higher, in the UK 0.75% higher, and in Australia at least 0.25% higher.
Interest rate markets don’t have to be right, but it is clear that traders are now looking at the state of oil and food prices and deciding that central banks have no choice but to abandon economies to their own devices and start hiking mercilessly should inflation begin to truly run out of control.
This is in contrast to the outlook assumed by the economists at TD Securities. At present those economists believe that economic growth will slow across the globe thus – with the usual lagged effect – inflation will begin to fall. Commodity prices will come down. TD sees the Fed on hold until at least well into next year and the RBA cutting before the year is out.
As far as views go, this is a bullish one for stock markets. High interest rates are the enemy of stock investment, as one requires a higher capital return to overcome the erosion of wealth caused by those high rates. That is why, under normal economic conditions, stock markets do not want to see a central bank raise rates.
It is, however, hard to know exactly what the US stock market was hoping for last night. A cut in rate would normally spur a stock market on, but at the moment a Fed rate cut would mean a lower US dollar, a higher oil price, and more pain for everyone. On the other hand, this would be good for people invested in energy companies, and good for struggling banks who need lower borrowing costs.
Had the Fed raised the rate, the US dollar would have taken off, and oil would have collapsed, and that would mean less pain for everyone. But investors in energy stocks would be buried, and struggling banks may soon have seen at least another one of their number go to the wall. By staying on hold, the Fed did just about the only thing it could do under the circumstances.
So what do we really want to see? Well outside of those invested in energy for the shorter term, we want to see the commodities bubble burst by itself – without intervention from central banks, and without major currency shifts. This would be like undoing central bank handcuffs, and it would provide a big boost for the wider global economy.
As TD Securities notes, were it not for the sudden recent burst in inflation, central banks across the globe would probably be reasonably content with the economic growth picture. The most recent data show the US is growing at about 1%, Europe and the UK 2% and Australia 2.5%. Under so-called “normal” circumstances all central banks would probably be eyeing off the next rate cut. But at the moment all the rhetoric is towards raising.
One must also consider that as far as long run averages go, there is not much deviation to today’s rate settings. The long run average in the US is 4.1%, against today’s 2%. In Europe its 3.5% against today’s 4%. The UK is 5% against 5.4%, and Australia 7.25% against 5.6%. Yet an argument can now be made to suggest that in this new world regime – one where developing economies are driving global demand – a higher level of inflation comfort should simply be tolerated, leading to slightly higher than average central bank rates.
Are so-called “comfort zones” of 2-3% inflation actually realistic anymore?
Even if the US were to make good on its hawkish tone, as indicated in the latest statement from the Fed’s rate committee, it still has 2% to go before it even gets to the average. Yet inflation hasn’t been this high for 15 years.
With developed economies around the globe looking wobbly, however, to hike rates now would be to administer pain. But it may be a case of another global recession “we have to have”. As TD Securities notes:
“Certainly, the rewards of sustained low and stable inflation are evident in the last 20 years in industrialised countries and, indeed, many emerging countries that have successfully embraced and achieved an inflation target have seen stunning economic performances locked in for the past decade or so.
“If central banks want to tolerate a year of pain to regain their inflation credibility, then they would likely do it.”
It’s been a great party. Is it time to go home?
