It’s been a dull week for keen interest rate watchers.
On Tuesday, the Reserve Bank of Australia decided to maintain interest rates steady at 2%. The focus then shifted to the US, where watchers hoped for some direction from the Federal Reserve. Overnight, the Fed released minutes from its September meeting, but it proved another damp squib.
You’ll have heard plenty about the timing of interest rate hikes by now. For much of this year, markets were convinced the Fed’s great lift off would begin in September. Yet September came and went, with no change in sight.
Attention now turns to November and December. Those meetings will present the last opportunities for the Fed to come good on its threat of raising rates. But few people buy the Fed’s doublespeak these days. Fewer still see any rate movement before next year.
As for the minutes, they revealed nothing you didn’t already know. We got the usual raft of banal justifications for holding rates steady.
Here’s the quick lowdown: the US economy is showing improvement, but inflation remains too low. Global growth is a major worry, and higher rates would crimp US exports.
For those following the Fed’s rate policy closely, this rationale won’t be news to you. You’ve heard this before, and you can expect to hear these same reasons trotted out time and again.
But not all of them are as important as the Fed makes out.
What we hear about less often is whether any of these reasons are warranted. Which factor really drives US interest rate policy?
It’s not inflation. It’s not the US economy. It’s not an uncompetitive export sector. I’ll get to why all that is shortly.
That leaves slack global growth as the only possible explanation. But the US has a major role to play in this slowing global growth, which the Fed conveniently never reminds you of. Having supplied much of the world’s capital over the past eight years, now their taps have run dry. The QE programs supported the rise of emerging economies dating back to QE’s introduction last decade. Now that the programs have ended, we’re supposed to be surprised that global growth is slowing?
The Fed was solely responsible for the QE programmes. And it shoulders much of the blame of emerging growth today. That it fails to mention the effects of this on the global economy, both then and now, is typical of its dishonesty.
But before we expand on this more, we can rule out some other factors first, starting with exports.
Why US exports don’t really matter to its economy
Higher interest rates do make US exports less competitive, as the Fed is quick to point out. As rates rise, the value of the US dollar grows too. Import costs go down, but export costs rise.
How important is this to the US economy? Not as important as you’d think.
Unlike most export driven economies, Australia included, the US economy isn’t particularly reliant on exports. Exports account for only one tenth of GDP. Compare that to Australia, where exports make up 20% of Australian GDP. In the event of higher US rates, the effect on exports would be minimal at best. Certainly less so than in Australia’s case. Let alone export dependent economies like China.
What’s more, the US exporting sector specialises in high end manufacturing. Which means it’s not competing with low end manufacturing exporters.
Take a look at the industries which dominate the US export sector.
Electrical equipment and fabricated metal products account for 6.8% of all exports. Medical equipment makes up 4.1% of all exports. Computer and electronic products: 12.8%; Machinery: 13.1%; Chemicals : 18%. And transportation equipment accounts for 19% of exports. Combined, almost two thirds of US exports are industries in which the US is a global leader.
Competing with US high end machinery and equipment isn’t possible for most nations. Very few are blessed with their level of expertise and technical knowhow.
All of which is to say that the effect on exports would be marginal at best. Especially when low-end manufacturing and resource exports, are where competition is most fierce.
Sure, the US does export resources too. Whether that be coal, oil, shale or otherwise. But its economy doesn’t depend on these sectors. It could easily weather any downturn in exports. Why? Because most of it would take place within industries like energy, where competition is high.
If exports don’t matter, what does?
For the US, what really counts is consumerism. The US consumer market is the largest in the world, at US$11 trillion. Consumption accounts for 70% of US gross domestic product, at the top of the global scale.
As far as American consumers are concerned, higher rates are a good thing. Why? Because it makes imported goods cheaper. And this forces domestic producers to lower costs too.
Low rates allow the Fed to keep a lid on the dollar’s appreciation. A weaker dollar adds pressure on the domestic price of goods. As cheaper imports flood the US market, domestic manufacturers have little choice but to lower prices too.
That leads to lower consumer prices across the board, benefitting consumers. Because of this imbalance between consumerism and exports, high interest rates wouldn’t be the death knell for the economy. Not to the extent the Fed lets on. Some industries, like food, would get thrown under the bus. But the economy would still keep consuming, which is what really matters.
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What’s keeping inflation low?
US inflation remains below the Fed’s target of 2%, at just 0.2%. So what’s keeping it so low?
The US housing market for one. House prices have recovered since the subprime mortgage crisis of 2007. But not enough to send inflation rising.
The other big factor is the effect of low oil prices, which is keeping inflation down. Crude oil is trading at US$45 a barrel. That’s down from US$100 a barrel in April 2014. The price of oil matters because it affects energy, transportation and industrial sectors.
Problem is, oil could remain low for a long time. Goldman Sachs forecast oil prices at US$20 a barrel by next year. And it thinks the price glut could keep prices low for the next 15 years. We might be waiting a while before the Fed’s big lift off in that case…
But why do inflation targets matter so much? Well, if interest rates rose, it’d raise the likelihood of deflation. Consumers would then put off spending in the expectations that prices would drop over time. And that’s not ideal for an economy so reliant on consumer spending. It also explains why the Fed is loath to life rates with inflation so low.
Of course, the vast quantities of US dollars floating in the global system are partly what keep inflation so low. In other words, the US exports its inflation, so to speak. And it won’t grow unless other nations dumped their dollar reserves back into the US.
You can forget about that happening as long as the dollar retains its global reserve currency status. As long as the dollar remains king in world trade, inflation will remain low.
The US economy shows improving conditions…or does it?
The Fed is reluctant about admitting the US economy is in worse shape than it believes. Presumably, that has something to do with maintaining ‘confidence’ across markets. But it’ll use inflation targets and exports before it ever admits the US economy isn’t really improving.
But in warped Fed logic, it says one thing and does another. In public, the Fed remains optimistic about the US economy. But in private, when it decides to leave interest rates on hold, it shows that it’s anything but.
The September meeting came before this week’s poor employment data. But it doesn’t really matter, as the Fed would have found a way of glossing over that, putting the blame elsewhere. How bad was it?
Well, the US economy added 142,000 jobs in September. That’s well short of the 200,000 jobs economists expected. If you’re wondering why adding any jobs could be a bad thing, it’s simple. Expectations matter more than reality.
The message is simple: the economic recovery isn’t as strong as the Fed makes out.
Interest rates or quantitative easing?
By a simple process of negation, we’re left with one final explanation for why interest rates aren’t rising…
Now, if you believe the Fed, it’s very concerned about a slowdown in global economic growth. It worries about what this might do to the US economy in the long run.
It’s funny watching the Fed point the finger at growth across emerging markets. Why? Because the Fed is responsible for this global slowdown. The Australian Financial Review explains:
‘The US Federal Reserve is just as likely to revert back towards quantitative easing as it is to lift interest rates, as corporate debt and emerging markets show the strains of a faltering recovery.
‘That’s the view of one of Australia’s top performing bond managers, Vimal Gor of BT Investment Management, who believes the unstoppable rise of the dollar will tie the Fed’s hands indefinitely.
‘The root cause of emerging market pain was a resurgent US dollar, Mr Gor said, which had left foreign borrowers scrambling to hedge their rising debt loads.
‘”It’s clear that the world is exhibiting a shortage of dollars here. Since the Fed QE program ended, world growth has slowed materially and numerous chasms are opening up.”
‘The fact that the dollar strengthened against the so-called commodity currencies even as the Fed stepped back from the September rate hike was evidence that the US dollar rally was moving independent of expectation of higher US rates, he said.
‘But the Fed has realised that the world’s problems were now its problems. The impact of weak global conditions on the US economy was the reason the Fed held off on the hike.
Mr Gor reiterated his long-held view that the Fed would be able to raise interest rates, taking the view that it was just as “likely that they do another QE package as they are to hike rates“’.
In other words, it’s not a Chinese or emerging market slowdown that’s the issue. The real problem is that US capital outflow has stopped. As the Fed’s QE programmes have wound down, it’s single-handedly jeopardised the world’s economic prospects with it.
And yet, as we’ve seen, this doesn’t really matter for the US economy. It will plod along with or without strong growth across emerging markets. It will be hurt by it, no question, but it will weather it better than any other economy in the world. The US may control the levers of world trade, but it doesn’t need it for its own survival. It’s the one nation on this planet that could thrive even if it closed itself off from the rest of the world tomorrow.
If that was the case, what’s stopping the Fed from hiking rates now? Because it doesn’t really matter, one way or another. It’s playing the good Samaritan, while the world makes a readjustment to slowing growth. Once markets come to grips with the ‘new normal’ of low growth rates across emerging markets, the rate lift off will begin in earnest.
Before that happens though, we can’t rule out the possibility of a fresh round of QE.
What about the RBA and the Aussie economy?
Quite simply, the longer the Fed delays hiking rates, the harder it’ll be for the RBA to hold off. Again, that’s because the RBA’s plank for economic growth relies on a weak Aussie dollar. Without that, sectors like education and tourism aren’t likely to lead any rebound. And you won’t see any service led recovery offsetting the slowdown in mining investments.
So the question for the RBA remains one of rate cuts, not rate hikes. Markets forecast a 30% chance of an Aussie rate cut by November, and 50% by December.
Contributor, Markets and Money
PS: The Reserve Bank is likely to hold interest rates at 2% when it meets today.
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