The US Federal Reserve (Fed) has just raised interest rates for the third time in a decade, in a significant acceleration of the pace at which it is tightening monetary policy. We believe further rate hikes are on the way – and at a faster clip than the market expects.
It is a common mistake to see the Fed as the sole, or even a major, determinant of the balance between savings and borrowing in the US. This balance is actually governed by the prevailing financial conditions in the world’s largest economy, which are derived from the level of lending, the cost of lending and asset-price growth.
While the central bank, of course, can affect these factors, it often only does so marginally. The Fed is not always in the driving seat.
As such, when deciding whether to tighten or loosen policy, the Fed should examine whether financial conditions are tight or loose. Failure to do so can lead to policy mistakes.
Since the election of US President Donald Trump, financial conditions have eased considerably, due the former reality TV star’s pledges to splurge on infrastructure and cut financial regulations. By some estimates, this has had the same impact as 75 basis points of cuts to US interest rates.
Against this backdrop of rising credit creation and climbing house prices, there has been a shift in tone from Fed officials of late, indicating that lessons have been learned from the monetary guardian’s policy stance during 2004-2007.
In the years before the crisis, the Fed allowed excessive leverage to build up in the economy by keeping interest rates too low, due to its fixation on inflation rather than credit. Yet inflation provided a false signal, because the fall in the value of tradable goods from Asian manufacturers and various other factors kept prices low. Under the surface, the economy was rapidly overheating.
We are not surprised, therefore, that the Fed tightened policy and we expect more rate hikes later this year. Markets estimate about two or three hikes this year; as the Fed, mindful of its past errors, will probably seek to lean against the looser financial conditions, this appears too low in our view.