If there is one thing that is certain about the outcome of this week’s Federal Reserve meeting it is that it is highly uncertain, with just under half of US economists predicting that rates will rise this week (chart 1), and just over half expecting the Fed to stand pat. 

 

 Chart 1: 

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Financial markets are even less confident about the likelihood of a hike, with the futures market currently implying a 28% chance of a September rate rise, and only about a 50% chance of a hike in 2015. 

 

There is no real economic justification for a rate hike this week (or even this year).  US inflation expectations are low and declining (see chart 2)

 

Chart 2: Inflation Swap Forwards 5Y / 5Y (Blue – UK, Yellow – US, Green – EU):2

Source: Bloomberg

 

US employment numbers are strong, but the participation rate (currently 62.6%) continues to languish at a 40-year low.  So, on either of the Fed’s two primary focus points, inflation and employment, it is difficult to argue that an interest rate hike is required.

 

However, the Fed’s dilemma comes not as a consequence of any conflict between, or interpretation of, its core objectives.  Instead, it is a third unofficial objective, the maintenance of (global) financial stability, which is causing the problem. 

 

For those favouring a rate hike, the financial stability argument is three-fold:

 

  1. The current ultra-low rate environment risks causing financial market bubbles (see chart 3), increasing systematic risk;
  2. The Fed needs to get ‘ahead of the curve’ to ensure rates can be cut when markets hit another rough patch; and
  3. The Fed’s credibility risks being eroded by constantly referring to a rate hike which never actually happens.

Chart 3:

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However, there is an equally compelling financial stability argument for the Fed to be patient, one which is supported by the historical record.  There are numerous examples, from Japan in 2000 (and 2006), to the ECB, the Swedish Riksbank and the New Zealand Reserve Bank more recently, where attempts to get ahead of the curve and raise interest rates early (i.e. before inflation becomes problematic) have back-fired, leading to abrupt policy reversals and damaged central bank credibility.

 

Hence the real dilemma underlying the Fed’s decision is as follows:  Does it risk its credibility by not acting when it said (or hinted) that it would, or does it risk its credibility by acting prematurely, and being subsequently forced into an abrupt policy reversal should its actions further destabilize already jittery financial markets?

 

As human beings tend to be biased towards action rather than inaction, and the reputational damage caused by a perception of complacency is often greater than that caused by misplaced, but well-intentioned effort, we suspect that there is a greater risk that Fed makes the second error.  This does not mean that interest rates will rise this week   (although they might), but that they will likely rise this year.  However, there is a very strong possibility (much stronger than what is currently being priced into the market) that the hiking cycle will be short-lived, and may even have to be reversed in 2016. 

 

Corbyn and the Currency

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On Saturday, the UK’s Labour Party, Her Majesty’s Most Loyal Opposition, elected Jeremy Corbyn as leader. Corbyn, a veteran left-wing political maverick, subsequently appointed as shadow chancellor by his friend and ally John McDonnell, another senior member of Britain’s long-suffering socialist movement.  Economic policies advocated by Corbyn and his new shadow chancellor include a top tax rate of 60%, re-nationalization of the British industry (notably the rail network and the energy sector), the implementation of a financial transaction tax, and a ‘People’s QE’ programme to pay for infrastructure investment, with cash printed for this purpose by the Bank of England.     

 

As such, it is fair to say that, as of this morning, Britain is closer to becoming a socialist state (republic?) than it has been for generations.  How close?  Well, the odds of Jeremy Corbyn becoming the next UK Prime Minister are now 7/1 (and remember, Corbyn has already overcome 100/1 odds to win the leadership of the Labour Party).  

 

Conveniently, the likely implications for the nation’s currency of a Jeremy Corbyn government have already been laid out in some detail in a novel published in 1982, entitled ‘A Very British Coup’.  Written by former Labour MP Chris Mullin, the book describes the unlikely journey to power of Harry Perkins, a popular and unassuming, and very left wing, champion of the working man.  Whilst the principled if slightly naive Perkins is the novel’s protagonist and the main victim in the novel is, without any doubt, the Great British Pound, which suffers crisis after crisis under Mr Perkin’s leadership (not all of which, it must be said, were entirely Mr Perkins’ fault).   Under Corbyn, it is unlikely that the currency would fare much better. 

 

By: Kevin Lester