Jerome Powell moves to normalize US monetary policy
All eyes were on Jerome Powell this week as he chaired the federal open market committee (FOMC) meeting for the first time since taking charge of the US Federal Reserve. How different will he be from his immediate predecessors, Janet Yellen and Ben Bernanke? And how will his monetary policy complement the fiscal expansion by the Donald Trump administration? Both these issues have profound implications for the global economy.
As expected, the committee that sets US policy interest rates increased them by 25 basis points. Apart from the policy action, financial markets all over the world were looking for the accompanying commentary and future projections of key economic indicators. It will also be interesting to see how the Fed’s communication evolves under Powell. He gave brief and direct answers in his first press meet while indicating that he would hold more press conferences. This should help improve the market’s understanding of the Fed’s position as it moves forward on the path of normalization.
Meanwhile, the projections released by the rate-setting committee showed that it expects a total of three rate hikes this year. However, the number of participants who expect four rate hikes has gone up compared to the December meeting. The committee also expects rates to go up at a faster pace next year compared to its December projections. While the FOMC raised its projection for economic growth and expects the unemployment rate to come down further, it kept its inflation projection unchanged for the current year and next year. However, it revised its core inflation projection, mildly overshooting the target of 2% in 2019.
The Fed expects the US economy to grow at 2.7% in the current year and 2.4% in 2019. The unemployment rate is expected to drop to 3.6% in 2019. Powell explained that while the unemployment rate has come down from the highs of the 2008 recession, inflation has not gone up, indicating that the relationship between inflation and unemployment—as captured by the Phillips curve—has weakened. As things stand today, this would mean that interest rates in the US will not go to the level seen before the financial crisis in the foreseeable future. The median projection for the federal funds rate in 2020 stands at 3.4%, compared to the high of 5.25% seen in 2006.
Nevertheless, there are at least three broad takeaways for the global financial market and policymakers from Powell’s first FOMC meeting as Fed chair.
First, the strengthening economic outlook for the US economy augurs well for the global economy. Continued recovery in the global economy will also help other central banks, such as the European Central Bank and Bank of Japan, to gradually unwind their crisis-era policies and move towards normalcy. The strength of the US and global economy will also support the ongoing recovery in the Indian economy.
Second, although the Fed expects to gradually raise rates, global financial markets may still find higher rates difficult to handle. For instance, the three-month dollar London interbank offered rate, or Libor, is at its highest level since 2008. Trillions of dollars worth of debt and interest rate derivatives are anchored to Libor. Higher rates could affect confidence and lead to higher volatility in financial markets.
Higher interest rates could also make debt servicing more difficult for a large number of leveraged firms across the world. Analysing a global sample of 13,000 companies, S&P Global Ratings recently found that the proportion of highly leveraged entities was 37% in 2017 compared to 32% in 2007. Also, the non-financial corporate debt has gone up by 15 percentage points, globally, to 96% of the gross domestic product between 2011 and 2017 (goo.gl/ba2P35). These companies will be in greater difficulty if the Fed raises rates at a faster pace. Although inflation has remained subdued in recent years, the possibility of a pickup in prices on the back of fiscal stimulus and lower unemployment cannot be completely ruled out. Higher rates could also lead to portfolio rebalancing by international investors. Foreign investors, for example, have sold bonds worth over $2 billion in Indian markets over the last one month.
Third, while the risk of tightening financial conditions is roughly balanced at this stage, the global economy is facing a bigger threat from rising protectionism. In his remarks, Powell also noted that a number of FOMC members reported that businesses are concerned by the change in US trade policy. More protectionist measures by the Trump administration could lead to retaliation by trading partners, which will inevitably affect medium- to long-term prospects for global trade and growth.
Ten years after the financial crisis, even as the Fed is carefully moving towards normalizing policy—though it may have to move faster if inflation surprises on the upside—the risk for the global economy at the moment is populist measures by the US government.
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