Who’s afraid of the US Fed?
The answer to the above question seems to be: “Certainly not the financial markets.”
At least, that’s what the Bank for International Settlements (BIS) is saying. In its quarterly review released on 3 December, the bank has tried to analyse what is fuelling market optimism, despite the US Federal Reserve starting to tighten its monetary policy.
Simply put, the policy doesn’t seem to be working, at least in the financial markets. In spite of the Fed Funds rate rising by 75 basis points (bps) since December 2016 and despite the Fed certain to raise rates again at its 12-13 December meet, financial conditions as measured by the Chicago Fed’s National Financial Conditions Index (NFCI) are now at a 24-year low, which means they are at their loosest since July 1993 (see chart 1). One basis point is one-hundredth of a percentage point.
The NFCI charts US financial conditions in money markets, debt and equity markets and the traditional and shadow banking systems. Positive values of the NFCI indicate financial conditions are tighter than average, while negative values indicate financial conditions that are looser than average. Note the loosening of financial conditions since the end of 2016.
Why are the markets ignoring the Fed tightening? BIS says the situation is reminiscent of the early 2000s, when Alan Greenspan’s policy of tightening in baby steps led to financial conditions remaining loose right up to early 2007. We all know that didn’t end well. The policy was also in marked contrast to the Fed tightening in 1994, which was much sharper and, as a result, unnerved markets.
Chart 2 shows how the markets and financial conditions reacted in the first year after the Fed tightened policy in 1994, 2004 and the current episode.
The chart shows that the present bout of tightening has been met with a collective yawn from the markets.
The reason for the boredom, says BIS, is the policy of gradualism the Fed is pursuing and the telegraphing of changes well in advance. The improved communication ensures the markets are not caught by surprise, while the policy of glacial gradualism strengthens the belief that central banks will rush to support the markets if they show any signs of wobbling.
One reason, as chart 2 shows, is that the Fed’s tightening has been very slow. That, in turn, has damped tightening expectations. The BIS report says that since December 2016, on average, market participants have been expecting policy rates to rise 40 bps over the subsequent 12 months. In sharp contrast, the market expected the Fed to raise interest rates at a pace of 100 bps a year, starting in 2004, and 160 basis points in 1994.
Of course, it helps that the US Fed’s balance sheet shrinking programme is so slow that the Federal Reserve Bank of New York forecasts a balance sheet size of around 15% of gross domestic product (GDP) as of 2025, compared with the 6% of GDP it was before the financial crisis. What’s more, the other major advanced economy central banks continue to expand their balance sheets.
The refusal of the financial markets to respond to the Fed’s tightening, says BIS, has led to complacency, which can foster higher leverage and risk-taking.
And indeed, margin debt has been going up in the US markets. BIS says valuations are frothy and unexpected rises in bond yields, which have remained remarkably placid so far, may catch investors off-guard.
There could be a rather simple explanation why central banks in advanced economies are in no hurry to tighten policy. Inflation this time is much lower, compared with the previous episodes of Fed tightening.
Chart 3, taken from the IMF’s World Economic Outlook database, shows GDP growth and consumer price inflation in the G-7 countries in 1994-95, 2004-05 and 2016-17 and 2018 (the numbers for 2017 being IMF estimates and 2018 are forecasts). Note that both GDP growth and inflation are much lower now than they were in 2004-05 and 1994-95.
To be sure, interest rates are much lower now than they were after a year of tightening in 1995 and in 2005. But then, this time, the tightening started from a much lower base.
Chart 3 also shows that the IMF thinks 2018 will see tepid growth in the G7 countries while inflation is expected to go up only marginally.
Going by the baby steps tightening trend of the early 2000s, therefore, when both growth and inflation were higher, monetary policy tightening by developed economy central banks is very likely to continue to be benign for financial markets. That will mean the conditions of plentiful liquidity in world markets will continue in 2018 as well.
The catch, of course, is that the boom of the 2000s led to a huge asset bubble and an equally spectacular bust.
What then is to be done?
Even the BIS doesn’t seem to have the answers. Claudio Borio, head of the monetary and economic department at BIS, says, “Can a tightening be considered effective if financial conditions unambiguously ease? And, if the answer is ‘no’, what should central banks do? In an era in which gradualism and predictability are becoming the norm, these questions are likely to grow more pressing.”
Manas Chakravarty looks at trends and issues in the financial markets. Respond to this column at firstname.lastname@example.org. Click here to read more columns by him.