Much ado about nothing

Does the US Federal Reserve’s decision not to raise interest rates matter to the global economy?

After nine months of intense speculation, the US Federal Reserve (the Fed) delivered its much-anticipated judgment on the strength of the US economy – by doing precisely nothing at its September meeting. Despite the siren call of many that US monetary policy had remained too liberal for too long, the combination of weaker Chinese growth, declining asset prices and a strengthening dollar all conspired to keep the Fed’s hand in place. With US rates having now been anchored at 25bp for nearly seven years, despite signs of economic normalisation investors have every right to question what (if anything) will drive a change in US rate policy.

Data dependency

Despite the Fed’s earlier guidance that investors could expect the first hike this month, the fact remains that the economic justification for such a move has become less clear as the year has progressed. Despite the unemployment rate falling to the Fed’s own estimate of full employment, wage growth and consumer sentiment have both remained subdued. Allied to the deflationary pressures emanating from China, it is hard to argue that the short-term economic case for higher rates was compelling.

Dammed if they did, damned if they didn’t – so are we all damned?

In many ways the current discussion over Federal Open Market Committee (FOMC) action manages to miss the key point of the policy debate, as the transmutation of monetary policy through the use of Quantitative Easing (QE) has over time become inherently damaging, driving an unstable increase in asset prices but little to fuel a sustainable economic recovery.

This contradiction lies at the core of the current policy dilemma. As Mervyn King pointed out in 2012, the purpose of QE is to bring forward tomorrow’s consumption to today. The problem therefore arises when tomorrow arrives. As we have previously pointed out, the relentless decline in corporate bond yields created by US monetary policy has acted to prevent a normalised default cycle, preventing a deeper decline into recession but also limiting the economy’s ability to recover. By preventing the “creative destruction” of a normalised credit cycle, the cheap funding currently enjoyed by the corporate sector has been recycled into share buy backs and M&A, rather than economically productive investment.

Does this really matter?

In a domestic context we would argue that the Fed’s decision does not. The Fed’s policy mistake lies not in last night’s decision, but in the failure to withdraw extreme stimulus earlier in the cycle. By allowing asset price inflation to significantly outstrip economic growth, the Fed appears to be exhibiting the same pro-markets bias currently being so widely criticised in China. Indeed, we would argue that the impact of a marginal increase in the federal funds rate is largely irrelevant to the domestic economy. Borrowing rates for most US citizens and small and medium-sized enterprises would remain unaffected even if the Fed had decided to hike. In this context, it is the recent rise in corporate bond yields and the dollar’s ascent to FX supremacy that is more relevant, acting to significantly tighten monetary conditions irrespective of the Fed’s action.

It is a similar story globally. By maintaining abnormal policy for too long, the Fed encouraged unhealthy capital flows and capital misallocation that has seen Asia’s stock of dollar denominated debt expand fourfold in just five years. With the prospect of higher US rates driving a sharp rally in the dollar, both the capital stock of outstanding debt and the interest service costs have risen rapidly in local currency terms. Seen against a back drop of declining Chinese activity and a corresponding decline in the region’s growth, the true consequences of tighter US monetary policy will continue to be felt outside the US.

Conclusions

Abnormally low interest rates and Quantitate Easing helped soften the economic decline of the banking sector solvency crisis. Hamstrung by the political inertia that prevented the use of wider policy tools, Central banks have become excessively reliant upon monetary policy to maintain economic stability. While the Fed’s overnight decision will be lauded and criticised in equal measure, the true policy mistakes lie back in 2012, with the announcement of QE3.

As is so often the case, market practitioners have rather missed the point over the FOMC meeting. Debates about the resilience of the US recovery and the strength of global economy in the face of a possible Fed tightening ignore the more obvious truth that the current system remains excessively reliant upon abnormal monetary policy for its continuous stability. The longer Central banks remain willing to flood the world with excess liquidity, the longer the wider required adjustments will take.