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The Fed fights the markets

John Redwood, Charles Stanley’s Chief Global Economist, looks at the Federal Reserve’s decision to raise interest rates.

by
John Redwood

in Features

21.12.2018

Equity markets have been falling since October, mainly through fears that the main central banks of the world are overdoing the monetary tightening. The leading banks of the US, the Euro-area, and the UK have been gripped by a new doctrine that they need to return to a more normal policy. This has meant the ending of all new quantitative easing in the UK, the run-down of bond buying in the Euro-area to end it this month, and quantitative tightening in the US as the Fed reduces the amount of bonds it owns. It has seen two rate rises in the UK from the bottom, and four rate rises this year alone from the US. Interest-rate sensitive sectors like homes and cars have been hit, as car loans and mortgages have become scarcer and dearer. The world’s second largest economy, China, has also embarked on its own monetary toughness.

This week the Fed spooked the markets with its decision to put rates up again by 0.25% and to forecast two more rate rises in 2019, with further to come thereafter. The Chairman of the Fed stated he was doing this in pursuit of a more normal policy, rather than setting it firmly in the context of his remit to keep inflation close to the 2% target. The Fed lowered its forecast for US growth next year to 2.3% from 3% this year and acknowledged that both the US and the international outlook is one of slowing growth. There are no obvious worrying inflationary pressures to satisfy the markets of a necessity for further rate rises. Mr Powell accepted that there had been a further monetary tightening this year and said that were the data to change adversely then so would the policy on interest rates. He merely shaded the previous forecast of three rises to two.

The President is angry about the path of Fed policy and has decided to make his displeasure known in public, which makes the Fed’s positon a bit more difficult. As an independent institution they do not want to follow White House instructions. The President wants to sustain growth in the USA above 3%, which requires more credit to be extended for investment and larger purchases. His fiscal stimulus was intended and he does not want to see it negated by a hair shirt money policy. Ironically it has placed the President in agreement with the markets, so whilst the President has no power to make the Fed behave as he wishes, the markets could have more eventual success in forcing the Fed to a less aggressive stance. It looks as if we are going to have to live with this struggle for a bit longer, with markets continuing to worry that the Fed is getting it wrong.

On the market side of the argument we have weak oil prices despite the sanctions against Iran and the production problems of Venezuela. There are no signs of shortages of main commodities or industrial products, with plenty of price competition in global markets. All now agree the US will slow, with the impact of the fiscal stimulus waning next year. The Eurozone too is slowing. On the other side of the world the second-largest economy, China, is going through its own monetary tightening as it battles to clean up some stressed bank balance sheets and eliminate some bad debts. There is no major source of monetary or fiscal stimulus worldwide to lead to faster growth. Real wages remain under control, with plenty of unemployed or people on low pay around the world willing to price themselves into the market by exporting to the US or by migration.

Defenders of the Fed say that the US economy is still growing swiftly, and will continue to grow next year. They agree with the Fed’s view that unemployment will fall further, creating tighter conditions in the labour market. They argue that the Fed will moderate its hawkish stance if the economy slows more than they expect. They want Mr Powell to resist the President’s hectoring tweets for the sake of good order. They think the markets wrong to be so worried.

It is never good when investors disagree with the most important central bank in the world. In due course, we expect the Fed to scale back its hawkishness further, as it is likely to figures will show a slowing and will demonstrate an absence of serious inflationary pressures. In the meantime there can be further falls as unhappy markets rail against what they see an insouciant Fed. The good news that the EU does not want to escalate its dispute with Italy, and the current attempt to find a deal to settle the China/USA trade dispute has been overwhelmed by the Fed. We will continue to watch the Fed carefully as the main current influence on markets. It still looks unlikely there will be a recession which means shares are good value. They will only go up when the Fed and the other central banks ease their squeeze a bit.

Nothing on this website should be construed as personal advice based on your circumstances. No news or research item is a personal recommendation to deal.

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