THE rate of interest is always the most important single variable in an advanced market economy. In the past few weeks, however, the intense concern about interest rates that is normal in the business community and financial markets has turned into a single-minded obsession. Whether we look at Britain, Japan, America or Europe, it seems that the prospect for interest rates is the dominant financial and economic concern.
In Britain last Thursday, the sad and unexpected death of David Walton, the distinguished economist who had been voting in the Monetary Policy Committee for an increase in the base rate, triggered the sharpest sell-off in sterling for six months. In Japan, as I wrote in this column two weeks ago, everyone is obsessed with the question of when the Bank of Japan will abandon its policy of zero overnight rates. In America, meanwhile, investors and economic commentators have been in a state of paralysed confusion since last week, when government statisticians announced a further uptick in the inflation figures, making an increase in interest rates inevitable at next Thursday’s meeting of the Federal Reserve. With headline inflation at 4.1 per cent and even the core rate, excluding food and energy, running at 2.4 per cent, well above the 2 per cent figure that Fed officials have described as the top of their “comfort zone”, the only debate is whether the Fed will move by a quarter-point, as normal, or whether it might consider a more dramatic half-point rate hike. But while this debate seems fairly fruitless, since a half-point move would be seen as a counterproductive sign of panic, the question that really is worth asking is what will happen after the Fed raises its interest rate from 5 to 5.25 per cent.
While a quarter-point rate hike itself will not make a huge difference to the world economy or financial markets, the statement from the Federal Open Markets Committee that accompanies the move on Thursday could prove an important event. My hunch is that the statement will be more hawkish than expected, strongly suggesting that another rate hike is likely and encouraging the markets to speculate about even higher rates beyond August. If I am right, then the Fed will hardly even hint at the possibility of a pause in the monetary tightening, even in the event of US statistics getting steadily weaker in the six weeks before the next meeting on August 8. Such an ultra-hawkish statement might initially upset investors and cause a sell-off in global financial markets, as prices adjust to a high probability that US interest rates will rise to 5.5 per cent and above. In my view, however, such a sell-off may well signal a turning point in the world economy and trigger a buying opportunity in financial markets — immediately for bond investors and after a while for non-cyclical, defensive equities, especially large-capitalisation growth stocks.
There are two reasons to believe that a hawkish statement from the Fed would be good news for the world economy and could prove surprisingly bullish for financial markets in the long term, even if it causes an initial shock.
First, because cyclical economic indicators, including housing market statistics and measures of consumer and business confidence, would probably be hit quite hard by the prospect of a much more hawkish Fed than was previously expected. A setback for consumer and business confidence might initially upset investors, but would actually be good news for the world economy and financial markets, since overheating and accelerating inflation, especially in America, has now become the main risk to the continuing global expansion. Thus anything that encourages American homeowners and consumers to slow down their borrowing and spending for a while, and instead do a bit of saving, would be very good news for the sustainability of US and global growth in the medium term.
But would investors respond positively to the prospect of an economic slowdown implied by tough language from the Fed? I think they would, though not perhaps at once. I think this partly because a weaker economy always tends to be received enthusiastically by bond investors, for whom inflation is always the greatest fear. In the present conditions even the stock market, which is starting to worry about recession almost as much as the bond market is fretting about inflation, might respond surprisingly well to a toughening of the Fed’s rhetoric. To explain this I come to the second reason for hoping that that Fed sounds as tough as possible this week: market psychology.
If the Fed manages to intimidate the markets, the US business community and the consumer with a really tough statement on Thursday, this shift in psychology may be enough to make another increase in interest rates unnecessary by August 8. What then would be the statistical requirements for the Fed to refrain from further tightening in August? The answer is simple: clear and unambiguous evidence of a slowdown in US economic growth. In order to end the tightening cycle, the Fed does not need to see inflation actually slowing, but it does need to get inflationary expectations firmly back under control.
From a strictly economic perspective, Ben Bernanke was probably right three months ago when he shook the financial markets with his hints of a pause in the Fed’s monetary tightening. As a theoretical economist he was perfectly justified in his prediction that the US economy would slow after roughly 18 months of monetary tightening and that inflation would decline after a further lag of 9 to 12 months. The problem was that while Professor Bernanke was right about the economics, he was totally wrong about market psychology. He should not have suggested a pause in the rate hikes at a time when the US economy still seemed to be booming, inflationary expectations and prices for gold, commodities and other inflation-linked assets were going through the roof.
But all that could change after Thursday, especially if the Fed accompanies its rate hike with some tough rthetoric. The key question will then be whether the Fed has done enough to stifle the speculative inflationary mentality that took over the markets in the first three months of this year. A pause by the Fed this week, as originally suggested by Professor Bernanke, would have been a big mistake, since it would have blown the Feds anti-inflationary credibility and created a bear market in all assets apart from commodities, gold and other inflation hedges.
By August the situation could be very different. As long as the US economy is clearly weakening by then, inflationary expectations will start to decline – provided only that the Fed can re-establish its credibility with some tough language.
