Fed

As the market awaits the Federal Reserve’s statements on Wednesday, the focus is on whether the FOMC will choose to signal a significant shift in a hawkish direction since its last meeting in July. Many investors believe that the key litmus test for this will be whether it chooses to drop two words from its July statement.

These words are “considerable time”. If that phrase disappears, then the market will need to absorb the fact that the Fed has deliberately chosen to force an upward adjustment in forward interest rate expectations, for the first time in this economic cycle. Read more

Paul Krugman has written two interesting comments (here and here) on my recent “Keynesian Yellen versus Wicksellian BIS” blog. Paul says that the Bank for International Settlements should not be labelled “Wicksellian”, and then asks a typically insightful question: what constitutes “artificially” high asset prices? Some of the discussion below on this point may seem a bit arcane, but in fact it could prove highly relevant for investors.

The crux of the matter is Knut Wicksell’s definition of the (unobservable) natural rate of interest, and its difference from the actual interest rate, as set by the central banks [1]. Krugman says that the Wicksellian or natural interest rate is that which would produce equilibrium between savings and capital investment in the real economy (“full employment”), and therefore leads to stable inflation. If the central banks set the actual rate below the natural rate, inflation will rise, and vice versa.

Since US inflation has generally been stable or falling for years, Krugman infers that the Federal Reserve must have been setting the actual interest rate at about the right level, or even too high (because of the zero lower bound). The further implication is that if current low interest rates are justified, so too are the high asset prices that they have triggered. In that sense, they are not “artificial” [2]. Read more

Janet Yellen has been nominated to take over as Fed chairman when Ben Bernanke steps down. Gavyn discusses with John Authers what a Fed led by Ms Yellen would mean for tapering and interest rate policy

In the past decade, the world’s central banks – first in the emerging and then in the developed world – have embarked on a Great Expansion in their balance sheets which is unprecedented in modern times. This blog sketches the anatomy of the Great Expansion and attempts to project what will happen as the US Federal Reserve tapers its asset purchases in the next 18 months.

The latest episode in the saga has, of course, involved the Fed’s attempt to distinguish between “tapering” and “tightening”, a distinction which the markets have been reluctant to recognise [1]. The US forward interest rate curve shows the first rate increase occurring very close to the time when the Fed is planning to stop buying assets in mid-2014. Whether it intended to do so or not, the Fed has de facto tightened US monetary policy conditions and will have to work hard to reverse this. Read more

The month just ended was the fourth worst month for government bond returns in the past two decades. This abrupt response to Ben Bernanke’s warning that the Fed might think about tapering QE at some point in the next few meetings has naturally raised fears that the great bull market in fixed income, which started in 1982, might now be threatened by a sharp reversal.

Some analysts regard this as the inevitable bursting of a bubble which has been created by the actions of the central banks (see this earlier blog). Others, like Jim O’Neill, regard the rise in bond yields as the start of a return to economic normality, and argue that would be a very good thing as long as it occurs in an environment of recovering economic confidence. Paul Krugman also points out that the pattern of behaviour in the major markets – bonds down, dollar up and equities up – is consistent with greater optimism about the US economy, rather than worries about the Fed or the onset of a debt crisis. Read more

The wobble in risk assets in the past week has followed the Fed’s shift towards hawkishness, weaker US jobs data and the budget announcement in Spain. The fact that eurozone equities have once again underperformed US equities suggests that the Spanish budget was probably the dominant factor.

As the first graph shows, Spain’s sovereign bond yields and bank CDS spreads have recently widened to near their worst readings since the crisis started in 2010. What is even more worrying is the consistent upward trend which is apparent in the data. The eurozone rescue operation, mounted by the ECB and heads of government last December, reversed this deterioration only temporarily, and markets now seem to have resumed their earlier adverse trends. Everyone is asking whether this will trigger a new, and larger, eurozone crisis in 2012. Read more

In the second half of 2011, the US economy appeared to buck the impact of the eurozone crisis, with American economic data surprising on the strong side in the final quarter of the year. But, as the new year begins, it seems improbable that economic activity in the US and the eurozone can remain so divergent for much longer.

Will the weakness in the eurozone eventually bring the US economy to its knees? Or will the greater resilience of the US win the day? The answer to these questions will determine whether the global economy will experience a double-dip recession in 2012.

The data released over the holiday period seem to be pointing in a more optimistic direction than markets have recognised. A year of above-trend growth certainly looks like a stretch in the present environment of fiscal tightening and global deleveraging. But the risks of a global double-dip recession appear to be receding, at least for now. Read more

The Fed decision was fairly close to what was anticipated in this earlier blog – all “twist” and no “shout”. However, on balance, the statement was slightly more dovish than I expected. Concerns about downside risks to economic activity were at least as great as in last month’s FOMC statement, with new downside risks from financial strains being specifically mentioned, and this has swayed the majority of the committee to introduce a slightly more aggressive operation “twist” than expected. Inflation concerns, while marginally greater than in the August FOMC statement, are clearly insufficient to impress the committee, which remains biased towards further easing even after today’s announcement.

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