US Federal Reserve : The States' multitrillion-dollar question

 

When will the US Federal Reserve raise interest rates and what will the fallout be? Peter Spence reports.

 

 Federal Reserve chairwoman Janet Yellen has become cautious about signalling changes of policy. Photo / AP

When you're running the most influential central bank in the world, you have to be careful with what you say. It's a lesson that Janet Yellen was forced to learn painfully during her first public outing as chair of the Federal Reserve.
Keen to respond to a reporter asking about when interest rates might rise in March last year, Yellen suggested that the Fed would start to increase these "probably something in the order of six months" after it ceased buying up bonds.
Financial markets reacted instantaneously. Yellen's offhand comment was interpreted as a clear sign that the bank would tighten policy much faster than expected, causing US stocks to tumble.
The episode serves as a reminder of why central bankers have become more cautious in signalling changes in policy, tiptoeing towards adjustments and introducing forward guidance to steer markets carefully.
It's been less than two years since emerging markets were last wracked by the decisions of US policymakers. As Yellen's predecessor, Ben Bernanke, made moves towards ending the Fed's bond purchases in 2013, the threat of a higher US dollar caused turmoil in foreign exchange and debt markets.

The fallout become known as the "Taper Tantrum", and in the period since the Fed has adopted a softly, softly approach to raising its rates, in part to help keep emerging market nerves at bay.
Brian Smedley, of Bank of America Merrill Lynch, is sure that the Fed has learned its lesson. "This painful experience reinforced the importance of effective central bank communication," he said.
In statements on monetary policy the Federal Open Market Committee has practically exhausted the linguistic constructions that could describe a measured approach to raising rates. Words and phrases such as "considerable period", "considerable time", and "patience" have become part of the language pored over by watchers hoping to divine when the Fed will eventually make its move.
Recent weak US data have set back the Fed's plans to lift its rates for the first time since the crisis. Domestic inflation remains well below the central bank's target, and for yet another year the US economy seemed to struggle in the first quarter.
But this soft patch is unlikely to cause the Fed to change course, and will more likely just prolong an eventual liftoff. While Yellen's misstep suggested that interest rates should have been raised last month, analysts do not expect to see the first hike until at least September.
When it does arrive, emerging markets could yet again be in for a shock. While the Fed has no mandate to guarantee a return to emerging market investors, this does not mean that the central bank will be oblivious of the risks of market panic.
At a press conference in March, Yellen made clear that the Fed did not want to move too soon in a way that could abort a "recovery that we have worked long and hard to proceed as far as it has". Partly a reference to a possible US slowdown, the chair was likely also acknowledging that premature rate rises could hurt the global economy.
If Fed rates were to rise sharply, this could cause chaos for economies with large dollar-denominated debts. Their currencies would likely fall, resulting in much higher inflation as their import costs rose. Emerging market central banks would be forced to hike their own interest rates, putting a brake on their economies.
Slower global growth might require the US central bank to double back on rate rises to support the domestic economy.
Any such U-turn would be an embarrassment for the Fed, which still carries the scars of 2013.
Close to two years on from the first Taper Tantrum, analysts have warned that many of the same economies are still vulnerable to Fed policy. Several of those in a precarious position at the time have failed to adjust in the intervening period.
In a now-infamous research note, James Lord, an analyst at Morgan Stanley, singled out five economies as particularly weak. Brazil, India, Indonesia, Turkey and South Africa became known as the "Fragile Five", picked for their large current account deficits, high inflation, and weak growth potential - all factors that made them vulnerable to the Fed.
Morgan Stanley last week revisited the group, as the Fed's most recent dovish tilt "allowed emerging markets some breathing space again".
Manoj Pradhan, an economist at the US bank, said vulnerable economies had failed to take advantage of the reprieve offered by the central bank.
"As a result, for the second time in three years, we have an emerging markets rally that has little fundamental support," he warned.
It is this view that has made many analysts nervous that a second Taper Tantrum could be uglier than the first.
Jose Vinals, IMF capital markets chief, warned last month of a brewing "super Taper Tantrum". As the Fed starts to raise its rates, emerging markets could face a rout worse than that of 2013, as Treasury yields and the dollar spike in union, he told the Financial Times.
Even while a rate rise by the Fed has been delayed, the dollar has been ascending. It has risen by 17 per cent on a trade-weighted basis since mid-2013, a move which BlackRock described as "challenging for countries and companies that have feasted on cheap US dollar debt".
Already, investors have become shy of emerging markets. Data compiled by NN Investment Partners (NNIP) showed emerging markets suffered some of their largest outflows in the past three quarters than during the financial crisis, soaring to US$600.1 billion ($1238 billion) over the nine months to March.
Maarten-Jan Bakkum, of NNIP, said that the figures showed expectations of a Fed rate hike had "already made markets quite nervous". The high level of outflows from emerging economies have rarely been seen before, notably around the time of the Lehman collapse and the Asian crisis of the late nineties.
The beginning of a Fed tightening cycle could herald the reversal of a multi-trillion dollar carry trade, which has seen investors buy emerging market debt with borrowed dollars. Bank of International Settlements data showed that international investors increased their emerging markets holdings by nearly 87 per cent from 2008 to 2012 to over $8 trillion, as they took advantage of low US borrowing costs.
Bakkum said that a Chinese growth slowdown has also likely contributed to a pullback from emerging markets. This combination of factors would mean that the outflows were likely to continue, he added.
"There might be some relief after two or three Fed hikes, after that theme has been digested by the markets," he said, but suggested it would be the middle of 2016 before emerging market investors "might start to be more relaxed about the situation".
Mike Biggs, an investment manager at GAM, has remained more sanguine on the prospects for emerging economies. "If you looked at the Fragile Five, you'd have to divide them up now. The manufacturers have improved and the commodity producers have suffered."
Anna Stupnytska, an economist at Fidelity Worldwide Investment, said: "Fed hikes in the coming months may initially put pressure on emerging markets overall: this will be the first hike for many years, and markets will need to digest this event at the time."
"Once this shock has been absorbed, and the adjustment period is over, the main story for emerging markets over the next few years is still one of differentiation," she said. Fed rate rises could end up being just another reason for investors to take a more nuanced looked at emerging economies.
Jobs gain shows growth on rise
United States employers added 223,000 jobs in April, a solid gain that suggests the economy may be recovering after stumbling at the start of the year.
The Labor Department reported on Saturday that the unemployment rate dipped to 5.4 per cent from 5.5 per cent in March. That's the lowest rate since May 2008, six months into the global financial crisis.
The figures indicate employers remain confident enough in the outlook to add jobs at a steady pace. That could help fuel a rebound after economic growth ground to a near halt in the first quarter. Yet the report included signs of sluggishness: March's weak job gain was revised sharply down to just 85,000 from 126,000.
In the past three months, employers have added 191,000 positions, a decent gain but down from last year's average of 260,000.
And the job gains aren't yet pushing up pay cheques by much. Average hourly wages rose just 3 cents last month to $24.87.
Wages are up 2.2 per cent in the past 12 months, about the same tepid pace as the past six years.