Beware rising interest rates

Central banks around the world are moving in a tightening direction, albeit at a different pace. The Fed under the Biden administration is different to that that served Donald Trump.

| 7 min read

The Fed as expected has turned very hawkish. The most recent minutes show that the whole Board is preoccupied by the high and rising inflation, an inflation they failed to forecast last year. They see a strong economy creating plenty of jobs, soaring house prices, a shortage of people willing to do a wide range of lower paid jobs and a good growth rate.

They do not seem unduly worried that their actions so far have led to rising mortgage rates, which will doubtless slow the housing market in the second half of the year. They are not concerned that people are now nursing some bruising losses on some shares and bonds. They do not forecast problems ahead from a slowing growth rate or tightening credit.

It is important to understand that this is a very different Fed from the one which President Trump bludgeoned into supporting financial markets and faster growth. Although it still has the same leader in Jerome Powell, he is chastened both by the attacks on the personal account dealings of Board members and by the failings of the Fed on his watch to grasp that it was overdoing the money printing and easy credit, triggering a worrying bout of inflation.

Whilst Mr Powell stayed on, there was substantial change at the top of the Fed with people more in sympathy with Democrat priorities brought in to key positions.

Mr Powell is a shrewd political operator who accepts the need to bend Fed policy away from the Trump focus on high equity prices and growth to the Democrat preoccupations with arresting inflation and pursuing diversity of the workforce. Whilst Mr Powell stayed on, there was substantial change at the top of the Fed with people more in sympathy with Democrat priorities brought in to key positions.

Senior Democrat Lael Brainard is the new vice chair. Philip Jefferson and Lisa Cook have been brought in as members to strengthen the Fed’s understanding of inequalities and the problems of employment for minorities. The biggest single change of attitude between the two Feds is that this one does not think it needs to go to the rescue of bond or shareholders. Where President Trump saw financial asset prices as a kind of running referendum on the success of his economic policies, the Biden Fed does not mind some losses for rich holders of financial assets.

The question that markets need to ask is why did central banks, led by the Fed, get inflation forecasts so wrong last year, and how far will they now go in correcting it after the event?

Inflation created by central banks

The Fed, the European Central Bank (ECB) and other advanced-country central banks carried on with creating money, buying bonds and keeping interest rates around zero for longer than they should in 2021 because they thought they would get away with it with inflation. They had got used to a decade of success with inflation in the wake of the banking crash of 2008 which had left banks more cautious about extending credit against a background of a large expansion of world goods capacity.

More globalised trade and the ubiquity of internet offers of supply on a worldwide basis underpinned these decisions. The collegiate committees of the central banking world reinforced each other's assumptions that they could run low rates and plenty of money for longer to ensure a better recovery without awakening the inflation dragon. They missed the signs of the retreat from globalisation all around them. Why be difficult around the committee table and question the consensus, which was bound to be popular in the short term with governments and opinion formers, as it was the easy option? The few members of these committees who did see the dangers or thought they should ask a few questions soon rolled over and accepted the consensus without much of a fight.

We are now witnessing attempted divergence between the” big three” advanced-country central banks. Japan still has no inflation problem, so it will continue with its years old policy of creating billions of new yen, buying government bonds to allow the government to borrow as much as it likes at zero interest. It will stay more popular with government and people, detached from the western realities. The Fed will be the arch hawk, repenting for its past excesses and driving firmly by looking in the rear-view mirror at the inflation it has created and not through the windscreen as the economy slows and bond prices fall.

ECB will stay loose if it can

The ECB will delay action and seek to support the peripheral economies as much as it dares. Its latest statements imply they think they now need to move to a more restrictive money policy to respond to the fast inflation it has triggered. The policy already announced is, however, in no hurry to slam on the brakes. It is going to undertake three more months of creating extra euro and keeping rates at zero, and then review the position in the third quarter of the year to see if it should end quantitative easing then. Markets assume it will have to stop it and bond markets are adjusting to the idea that there could be a rate rise to follow the end of money printing before the year is out. The language of the ECB is more nuanced, as it clearly wishes to keep open the option of not doing that any time soon. They also stress ending QE does not automatically lead to a rate rise.

Markets are dragging and will drag European bonds further down in sympathy with US ones despite the different policy and tone. They think the state of fast inflation, with Spain at an alarming 9.8%, and the transatlantic pull of money into dollar deposits boosted by a higher interest rate will force the pace on tightening in Europe. The ECB however will be more reluctant for political reasons. Their sovereign the EU Commission and Council will want no shocks to the peripheral economies in the long run up to the Italian election. They will currently wish to avoid higher mortgage rates in France as they will be keen that Macron defeats Le Pen. The Euro area has plenty of debts particularly in the southern states which high interest rates would make problematic.

We are not yet at the point where bond markets have fully adjusted to the new realities. Interest rates will be rising in the US. There will be increasing pressure on the ECB to take inflation more seriously in Europe. We will learn again that the US has a big influence over the other main currencies and financial markets of the free world. It is taking time to sort out the many supply problems from energy to microprocessors and from various types of employee to transport capacity. There is still uncomfortable news ahead about inflation before bond prices can look forward to the peak of the rate cycle.

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Beware rising interest rates

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