Ah, September. After all the chaos of trips, camps and late bedtimes—the structure of the school year and its predictable routines are a welcome change for parents and kids alike, even if we’re all a little more exhausted than usual.
Of course, in my line of work, predictability is always desirable—especially with respect to the actions of the Federal Open Market Committee (FOMC). They met this week to discuss interest rate plans and the timeline for trimming the Fed’s balance sheet.
And lucky for us, the outcome was as expected: no increase in rates right now, a forecast of modest increases on the horizon, and a gradual decrease in the balance sheet starting next month.
So it appears the Fed will continue to support the U.S. economy while it carefully backs away from Quantitative Easing (QE).
But everyone’s working, right?
The U.S. labour market is strong, so it might seem strange that the FOMC has hardly touched interest rates so far. The reason is that inflation remains below their 2% target, signalling that the economy still needs low rates as stimulus.
The situation is puzzling. Since 2008, QE has swelled the Fed’s balance sheet with $4.5 trillion worth of government bonds and mortgage-backed securities to stimulate the economy. Furthermore, unemployment in the U.S. is at a point in which the Fed—and economists in general—expect inflation to start accelerating. How can inflation still be so low?
A few possible reasons:
- The modest growth we’ve seen in this cycle translates into slower revenue increases for businesses. As a result, they can only raise wages so much, leading to fewer dollars in circulation than might occur with faster GDP growth and higher wages.
- Wage inflation has also been held back by slower productivity gains since the Great Financial Crisis and shifting demographics.
- Ever increasing globalization has given countries the ability to "import" lower inflation from other countries with cheaper labour, and goods and services.
- More recently, the oil price crash of 2014 reduced inflation.
However, we need to keep in mind that inflation is a lagging indicator. It can creep up and rise fast.
Not today, not tomorrow… but soon… and (hopefully not) for the rest of your life
Regardless of why it hasn’t happened, we have to assume inflation will increase eventually. It’s a matter of time and how the central banks will manage it.
Governor of the Bank of Canada, Stephen Poloz has talked about tapping the brakes (by raising rates) before reaching the inflation target, for fear of reacting to a detrimental increase years too late. The Fed’s consensus opinion that they will gradually raise interest rates—once towards the end of this year, twice in 2019, and three times in 2020—might reflect similar thinking.
I don’t envy them. Predicting when the economy will overheat is no easy task. Amid the backdrop of QE and similar monetary policies, inflation can easily blow past targets, and by that time you’re already in a recession.
The U.S. economy is balanced and strong, more so than any other developed country. So I think the Fed is wise to start making progress towards normal interest rates.
No more taper tantrums
When former Fed Chairman, Ben Bernanke first talked about the prospect of normalizing the Fed’s post-recession balance sheet, markets went crazy. Now the FOMC has said the process will start in October, with a much milder reaction: the U.S. dollar jumped, the Canadian dollar declined, and bond yields increased.
The markets have had four years to digest the tapering concept. Furthermore, the Fed announced a very gradual process. It doesn’t even plan to sell its bonds and securities, only to stop reinvesting their proceeds in new ones—by $10 billion per month to start, and later, up to $50 billion per month.
At this rate, the reduction in the balance sheet through the early 2020s will be small. Moreover, when the Fed stops buying, other central banks will be eager to follow their lead at some point. For example, the European Central Bank and the Bank of Japan’s recent purchases dwarf what the Fed is looking to shed. So interest rates shouldn’t rise rapidly.
As for us, the Bank of Canada has been raising rates gradually as well. We’ve seen two bumps this year—in July and September—based on the continued strength of the Canadian economy. But going forward, I don’t think they’ll raise rates faster than the Fed does.