FED and fistful of dollars

FED and fistful of dollars

dollar

 

Ralf Waldo Emerson once said, that the money often cost too much. He is an American writer, who dedicated his life to the fight for individual freedom – something that, from today’s perspective, is considered a typical trait of American capitalism and a basic human right. Of course, living in the 18th century, the author had no concept of central banks and their policies, which reached new heights after the last global crisis and demonstrated to us that, when the central bank decides, money can cost too little.

 

After 2008 US government started stimulating the economy and the banking sector in particular, by using various monetary tools. The officials introduced so called Quantitative easing (QE) programs and many tax breaks for individuals and business organizations, while the base interest rate (so called Fed funds rate) dropped to zero.

 

Fed’s Bazookas

 

What is Fed funds rate? All depository institutions in USA are obligated to maintain some minimal reserve in form of deposits at the central bank. Those of them having surplus on these accounts can lend money to those, having shortfalls. The annual interest rate on these overnight loans is determined by the US Federal Reserve (Fed). In reality, this base interest rate is not obligatory for the banks. Nevertheless, it is targeted by the Fed, meaning it is maintained by the central bank through the sale and purchase of financial assets – so called operations on the open market. Part of these assets are US treasury securities. Federal Reserve is the institution that has the authority to issue US currency. In other word, any change in the Fed’s base interest rate has direct impact on the value of dollar denominated assets all over the world – from interest rates on dollar denominated debt, through the various financial derivatives such as credit default swaps, to the commodities traded in US dollars such as oil.

 

Quantitative easing (QE) is another instrument, which was used in USA as method for dealing with the crisis. In short, Fed bought bonds owned by the banks and other financial institution. The main goal of this quantitative easing is to make money available to these financial institutions and by this to stimulate them to lend to the business.

 

In 2013 central bankers started reducing their purchases of assets, through which the program was implemented. On 16 December 2015 Fed raised its main interest rate going from 0-0.25% to 0.25-0.5% range. This was the first hike since June 2006 when chairman of the Board of Fed an FOMC was Ben Bernanke and the Fed funds rate at the time was 5.25%.

 

The main goal of Fed:

 

  • ▪Rising employment – The idea behind this is to use the instruments available to the Federal reserve to stimulate business investments, which in turn to lead to new job openings.
  • ▪Encouraging lending – Fed’s main argument is that its actions (purchase of government bonds) will reduce long-term interest rates and accelerate lending.
  • ▪Measures against deflation – The appearance of deflationary pressures means drop in the prices of the goods and services due to weak demand, which leads to lower business profits, job losses, bankruptcies, etc.

·

The main argument of the central bankers is that the price inflation in the traded assets will increase households wealth and will stimulate consumption and investments.

 

One thing is certain – the stimulus program became a vital point in determining investor sentiment. And yet, did the Fed achieve its goals and stabilize the economy?

 

  • ▪Unemployment rate, which rose to 10% in 2009, fell to 4.7% at the beginning of 2017.

1

  • ▪Lending – up from 6.67 trillion dollars in 2010 to 9.41 trillion dollars in 2016.

2.eng

  • ▪Inflation – in 2009 the US economic experienced deflation of -0.39%. At the end of 2016 the reported inflation was already at 2.1%

3

  • ▪Capital markets – Dow Jones Index bottomed at 6 547 points in March 2009 only to peak at 19 954 points at the beginning of 2017. The movement of S&P 500 index was similar – from 735 points in February 2009 to 2 275 point in January 2017.

 

The rise in the main stock exchange indices is also a consequence of the Fed’s policy measures. Although not explicitly included in the central bank’s mandate, Fed’s members have often stated in interviews that price inflation in traded assets will increase households’ wealth and will stimulate consumption and investments.

4

By the end of 2016 inflation in USA was grew to 2.1%, unemployment fell to 4.7% and main stock market indices reached record levels. The main goals of the central bankers seem almost achieved, although there are some aspects of economy that are still a cause for concern for the members of the Federal Reserve. The central bank took the path to interest rate policy normalization in December 2015 and many analysts expected to see four rate increases in 2016. That did not happen due to several reasons of a different nature. The year started with the fears for the sustainability of the Chinese economic growth and strong drop in oil demand, which pushed the prices below 30 dollars/barrel. All this happened straight after the interest rate increase in December 2015. These several factors hit global capital markets and resurrected the ghost of uncertainty. After subsequent stabilization, we entered in the political season. Two referendums in Europe and the presidential election in USA imposed a challenge for the investors and, expectedly, the Fed members were in no hurry to proceed with a new hike. Surprisingly, neither Brexit nor Trump victory were predicted by the poll agencies and thus, giving raise to contractionary and volatile market reactions, while the outcome from the vote in Italy in December 2016, which was largely expected, did not have that kind of effect. Uncertainty on capital markets combined with the busy political schedule did not provide Fed with the desired environment to raise rates further and we witnessed only one increase in 2016, which was consequence of good inflation data, annual wage growth of 2.9% and good investor sentiment.

 

What to expect from Fed in 2017?

 

We cannot answer this question without considering the effects of the economic program of the newly elected president and its assessment by the Fed members.

 

Donald Trump’s economic program.

 

One of the main pillars of Donald Trump’s economic program is the strong reduction of personal and corporate taxes. Because of this tax policy, US budget is expected to lose 9.5 trillion dollars in tax revenues in the next 10 years. The president proposed zero tax rate on income below 29 000 dollars and if the annual income exceeds 154 000 dollars, the applicable tax rate will be 33%. Reduction of corporate tax from 35% to 15% and simplification of tax code is also part of the proposal. Protectionism is another basic element of his economic policy, as he plans to impose a 35 % duty on all Mexican products and 45% – on Chinese import. The new president also plans to invest approximately 1 trillion dollars in infrastructure, to increase military budget and to remove many of existing regulations. According to the economic theory, the growth in disposable income because of lower taxes and higher government spending will drive inflation up. Given these projections and the currently prevailing fed funds rate in the range of 0.5-0.75%, there is a risk that inflation could accelerate faster than anticipated by the regulators and become harder to control.  Fed’s assessment It becomes clear from the protocol of the central bankers’ meeting in December that they believe more interest rate increases could be necessary in case the US Senate approves the majority of the tax reforms included in Trump’s program. All Fed members expressed the opinion that the risk of economic growth exceeding their forecast has increased due to the possibility of more expansionary fiscal policy. After the meeting, the institution’s chair Janet Yellen said that Fed operates under “cloud of uncertainty” with respect to the expected amendments in the tax legislation and government spending under the new president administration and US Congress. Fed board members announced that they set their forecast for GDP growth slightly higher because of their expectations that tax reform and government spending will be more supportive for the economy than they have been in the past few years. Despite the “risk of improvement” resulting from a possible fiscal expansion, there are also risks related to unexpected factors such as the additional appreciation of US dollar, the  vulnerability of foreign economies, as well as the fact that the main interest rate remains close to zero. I would like to draw the attention to one of the Fed’s members –  Eric Rosengren –  who doesn’t have the right to vote in FOMC sessions this year. For a long time, he was considered a more cautious economist who supported low interest rates as a tool to stimulate the employment, even at the cost of higher inflation. In the course of the past year, however, he took a more hawkish position, calling for higher rates in times when Fed refrained from action. According to him Fed must accelerate the pace of monetary tightening, otherwise it may face risks from rising inflation. He expects monetary policy to normalize faster in 2017 compared to the previous year.   In Rosengren’s opinion, at 4.7%, the level of unemployment is considered sustainable in the long term and inflation at the end of 216 is close to the Fed’s target of 2%. There is concern, however, that without further monetary tightening, the unemployment will fall below its natural level pushing inflation above the target rate of 2%. The economist insists that the Fed’s monetary policy will need modifications to avoid the risks for the economy arising from deviations from Fed’s dual target. The president of The Federal Reserve Bank of San Francisco member of FOMC John Williams sees solid reason for three interest rate hikes this year. According to him, even without Trump’s measures for stimulating the economy, if economic growth increases faster than expected, Fed also will need to speed up its policy of “normalization”. Another member of FOMC, Lael Brainard also joined the group of those who warn that the widening of the budget deficit will push inflation up.

 

Potential candidates

 

Janet Yellen’s mandate expires in 2018 and the newly elected president has not hoven any indication whether he would nominate Janet Yellen for a second term.  Fed observers see Glen Hubbard of Columbia University, John Taylor and Kevin Warsh from Stanford University as main potential candidates for the position of chair of the Board of Governors of the Federal Reserve System, in case president Trump decided not to nominate the current chair Yellen for another 4-year mandate. The potential candidates said that, if they were in position to lead the central bank, monetary policy would had been tighter. During his election campaign, Trump criticized Yellen for keeping rates lower, which he saw as support for the candidate of the Democrats.

 

Hubbard, who was chairman of the Council of Economic Advisers under president Bush, expressed his approval of the Trump’s position that the US economy has been too dependent on Fed’s support in the recent years. He says that Fed could accelerate the pace of rate hikes if there are signals that Donald Trump is going to fulfill his plans for tax reductions and higher spending on infrastructure.

 

Warsh, who is a former Fed member and executive secretary of the National Economic Council under Bush presidency, said that Fed missed opportunities for increasing the rates, pursuing short-term policy goals. He is surprised that the main interest rate remains so low given that Fed is so close to achieving its main policy goals concerning unemployment and inflation.

 

Which are the risk in front of Fed?

 

First of all, the policy of the new elected president sparks fears of the potential trade war, which he might start. The coming year will reveal whether we will witness a trade war with China and stronger dollar. Both scenarios are not supportive to the US economy.

The dense political calendar in Europe is the second factor, which can influence Fed policy. There are general elections coming in France, Germany and the Netherland, while the official “Brexit” procedure is also expected to start this year All of this is going to happen with the unresolved Italian bank crisis and insignificant economic growth in EU in the background.

 

While Fed is considering tightening of its monetary policy, other institutions such as the European Central bank, Bank of Japan and Bank of England, still use asset purchases and low rates to stimulate inflation and economic growth, which in turn reduce the exchange date of their currencies against the US dollar benefiting their export.

 

The third consideration is related to the current level of indebtedness. Global corporate and public debt reached above 152 trillion dollars. Every rate hike it’s going to complicate the debt service. Reducing the tax and fiscal stimulus – measures, which the new US president intends to use – will add another 5.3 trillion dollars to the existing 20 trillion dollars of US debt.

 

Fed’s monetary policy will also bear the influence of the actions undertaken by Chinese authorities, who continue to struggle with the critical imbalances accumulated over the years in the second-largest world economy. Another challenge is also rising – the proclaimed aggressive trade policy of Trump, aimed at reduction of the trade deficit with China. Possibility of another sharp yuan devaluation in response to this policy it is not insignificant should this happen, the Fed would have to seriously reconsider its policy. In the coming year, the Fed policy will be a function of the policy measures implemented by president Trump and the path of the US dollar. On one side, the expected tax cuts and fiscal stimuli will be catalysts of inflation but on the other, potential dollar strength arising from higher interest rates can threaten the economic growth in a moment, when other central banks maintain accommodative monetary policies. Eventually, irrespective of the particular currency or central bank actions, the world is slowly entering a period of monetary tightening, in which Ralph W. Emerson’s words that money often cost too much, start to make sense again. After all, when it is a question of money, we are all of the same religion. And no, these are not words of Trump or Janet Yellen. Voltaire said it!

 

By Pavel Bandilov

Leave a comment

More
The Nation-building of a European Superstate

The Nation-building of a European Superstate

  Democracy as a contemporary political system in post-communist states raises the notion of how to build a bridge between…
The Ideology of Radical Islam

The Ideology of Radical Islam

  This article is based in part on Alex Alexiev, Radical Islam and its Threat to the West and the…
The clash between collectivist sentiment & Bulgarian civil liberty

The clash between collectivist sentiment & Bulgarian civil liberty

A libertarian introduction to an authoritarian matter Historical evidence proves time and time again, that the concentration of power in…