As was widely expected by markets, the Federal Reserve’s Federal Open Market Committee (FOMC) hiked its federal funds policy rate by a quarter point last week. It’s been a year since the Fed inaugurated this hiking cycle i(back n December 2015) and remarkably this is only the second rate adjustment since December 2008.
BlackRock has predicted this interest rate hike previously which comes in a year which saw turmoil in Chinese trading and Japanese monetary policy, followed by the recent shock election wins for Brexit and Donald Trump.
“We think U.S. policy rate normalisation is long overdue, and more interestingly, we believe the move reinforces a broader global policy evolution, or regime change as we’ve referred to it elsewhere, involving a reduction in monetary policy influence and a turn toward fiscal initiatives,” says Rick Rieder, Chief Investment Officer of Fundamental Fixed Income at BlackRock, and Co-Manager of Fixed Income Global Opportunities (FIGO)
The experts at BlackRock see two more interest rates in the US from the Fed in 2017.
In the U.S., this policy evolution isn’t necessarily surprising, coming as it does after the economy has achieved a nearly historic 4.6% unemployment rate, with more than 15 million people hired since 2010.
What was somewhat surprising was the moderately hawkish tilt in Committee members’ year-end projections for the fed funds rate in 2017 and while this could well be the realisation of reflationary potential being a bit stronger today than a few months back, the reflationary impulse isn’t limited to the U.S. per se.
“We Identify September 21 as just as critical a date of policy regime change,” says Rieder. “On this day, the Bank of Japan unexpectedly announced a shift away from its emphasis on negative policy rates and instead put forward a significant policy adjustment and plans to overshoot its 2% inflation target in an intentional manner. In our view, their intent is to modestly steepen the yield curve, helped to improve financial-sector profitability, which had suffered under the negative rate regime”.
Similarly, Brightrock suggest that renewed interest in letting yield curves steepen, and engineer moderately, but not excessively, higher rate levels, was evidenced by the European Central Bank’s recent “non-taper taper,” although the ECB may have missed an opportunity for even bolder and more productive policy change.
Ultimately, these specific directives toward steepening yield curves, and seeking a more productive equilibrium between monetary and fiscal policies should be beneficial to financial transmission mechanisms and consequently to re-rating growth and inflation higher in these regions.
It is also critical to understand that most developed market central banks are coming to believe that at this stage very low interest rates, especially negative rates, and flat yield curves for long periods of time hold little utility for supporting growth in the real economy.
“The view that adequate and effective financial transmission is much, much, more important to the overall health of an economy, and particularly, to imbuing the system with higher levels of inflation is now coming into focus. In essence, we would point to our view that MV=PQ is still the fundamental principle in economic growth and inflation, and thus as M (the monetary base) grows, it doesn’t create any growth or inflation if velocity (V) shrinks due to impaired financial systems that struggle to build net interest margins, or capital, and thus are reluctant to lend and instead are focused on shrinking their businesses,” explains Rider.
The move by the Fed, and the elevated changes in Committee members’ SEP rate forecasts balance alongside the idea that Chair Yellen has put forth of allowing the economy and inflation to run hotter for a time, in an attempt to heal the damage done by the financial crisis and recession (particularly with slow wage growth, now turning higher).
When placed in the context of policy rate normalisation, and potentially significant fiscal stimulus from a U.S. government now unified under the Republican Party, experts are left wondering if America has reached the end of a period that has been characterised by excessive central bank accommodation, financial repression, low growth, low inflation, low yields, and low terminal rate expectations.
“We think excessive pessimism is overdone, as the hallmarks of this new policy and market regime are clearly reflation, inflation, and greater optimism that a more productive balance between growing fiscal and receding monetary policy stimulus can be found,” says Rieder.
“Of course, we would be the first to point out that this optimism has its limits, as structural changes to the country’s demographic profile and rapid technological change cannot be altered meaningfully. Still, within a range of “what is possible,” there are reasons to believe the new regime can run a bit, even with periodic retrenchments as markets get ahead of the facts on the ground. As a result, from an investment perspective, we think TIPS (breakevens) look much more attractive than nominal Treasuries at this stage,” he concludes.
Markets have been reacting to this policy regime change, even before the U.S. election kicked it into high-gear, and in addition to more traditional forms of fiscal policy stimulus (reduced taxes, and greater spending on infrastructure and defence, for example).
A damping down of some of the inefficient regulation, while keeping thoughtful regulation, is the other positive catalyst for this improvement in financial transmission and velocity. It appears that the central banks are now heading down more appropriate policy paths, and markets are likely to be well supported, rates can move moderately higher, inflationary expectations can continue to accelerate, and most importantly, economic and financial investment can and will grow alongside of this. This progress will still have setbacks, and other bouts of political risks could well jolt markets in the year ahead, but alongside higher levels of volatility, markets will be encouraged by a more sensible policy mix that stands a better shot of improving growth prospects for a broader population.