The tug of war between the Federal Reserve and the markets

The US Federal Reserve raised interest rates again yesterday.

US rates fell to near-0% back in 2008. At the time, it was seen as an emergency measure.

Now, not far off a decade later, the Fed’s key rate has just crept back above 1%.

And what’s the market’s biggest worry?

That the Fed is moving too fast…

How the US central bank plans to unwind its balance sheet

Last night, the Federal Reserve (the US central bank) raised interest rates for the second time this year. The federal funds target rate now stands at the giddy heights of 1-1.25%, up from 0.75-1%. The move was expected and the market had pretty much priced it in.

The next big question is unwinding quantitative easing (QE), and the Fed gave us more details on that too. Here’s the plan.

The first thing to understand about QE is that in some ways, it hasn’t ended, not even in the US. The Fed printed money to buy lots of US Treasuries (government IOUs – it bought some other stuff too, but let’s stick with that to keep things simple).

In doing so, the Fed expanded its balance sheet, and pushed a load of new money into the economy. It also drove down long-term interest rates by providing a huge source of demand for US Treasuries, with the Fed competing with other potential Treasury owners.

However, those bonds have a shelf life – they’re IOUs, so at some point the government repays them. The government still needs to borrow that money (the US is running a deficit, just like us), so it just replaces this debt by issuing more debt. This is called ‘rolling over’ the debt.

At the moment, as soon as one bond matures (ie the government repays the debt), the Fed just takes the money and uses it to buy another Treasury. So the Fed’s balance sheet remains the same size, and the US government has a guaranteed customer (itself, effectively), for its debt.

The next step is for the Fed to shrink its balance sheet. It won’t do anything as radical as selling the bonds it owns. It just won’t reinvest the money from the maturing bonds.

The plan is to do this at a rate of $10bn a month. This “run-off rate” will rise gradually (by $10bn every three months), until it hits $50bn a month. That’s a very slow and steady pace. As Paul Ashworth of Capital Economics points out, “the Fed added assets at $85bn per month during QE3 and currently holds more than $4trn of assets”.

The Fed seems to expect that it will start this process at some point this year. Meanwhile, it also expects to raise interest rates once more this year, and three times next year.

No sudden moves and nothing too radical there. What could possibly go wrong?

Is the Fed moving too quickly?

Well, astonishing as it may seem, the big fear in markets just now is that the Fed is raising rates too quickly.

Here’s what’s concerning them. In the UK, the Bank of England has been very successful at missing its inflation target, helped by a weak currency. Consumer price inflation is sitting at 2.9% (versus a target of 2%). The fact that price inflation is outstripping wage inflation isn’t so great. But the UK currently is not flirting with deflation.

In the US, inflation has been much less co-operative. In February, US inflation was up 2.1% on the year. In March it slipped to 1.9%. In April, it was down to 1.7%.

This is all happening despite US unemployment being extremely low. You’d think that – with lots of people in work – that wages would be going up at a decent pace. So far, that’s not happening.

What markets really want to see is a “dovish” rate-hiking cycle, as Bloomberg puts it. This is when “real” interest rates (ie interest rates adjusted for inflation) keep falling, even although nominal interest rates rise. In other words, inflation rises faster than rates do.

That means monetary policy is really still loose, and it also means that debt is still being gradually inflated away. That’s what the market wants to see, and right now it’s not getting it.

Markets are worried that, instead, the US economy is going to go pear-shaped, particularly now that Donald Trump has proved incapable of getting any sort of deal done on anything. The fear is that Fed chair Janet Yellen is just getting enthusiastic about the idea of raising rates when the economy is about to have another slump.

So why was the market reaction relatively sanguine yesterday? Simply put, the markets don’t yet believe Yellen. Market expectations for where future interest rates will be are well below where the Fed currently reckons they’ll be.

Who’ll win? It all depends on what happens to inflation data and growth prospects over the coming months. To my mind, the danger is that with the post-election euphoria all gone, and no more stimulus from the Fed, an expensive market may lose the will to keep rising.

But I’ll keep an open mind. Pay close attention to what happens to the dollar. It’s still one of the most important prices in the world as far as broader financial conditions go. If it starts going back up, be ready for turbulence.

(By the way, we look in a lot more detail at what we view as some of the most important financial and market indicators in the MoneyWeek Unlimited email every Friday. It’s available to MoneyWeek subscribers only – if you’re not already a subscriber, sign up here).

  • Andrew Crow

    John, you ask ‘Who’ll win?’

    Your guess is as good as the next man or Janet Yellen.

    What we can guess who is going to lose; same people who always pick up the tab.

    • DemiGod

      Mr Market always wins in the end, goes longer than any politician can manipulate. But it requires patience – lots.

  • Richard Stead

    I note wages are not rising as fast as inflation, but if we had deflation they would be going up in value all the time. What’s with this desire to boost inflation? If governments can borrow for next to nothing, then as debt matures they can change it for cheaper debt as long as they can keep interest near zero. It is a win win situation. Deflation? Long may it last.