Investments

Shadow of GFC over unflinching US economy

Spotlight May 2017

Mark Rider explains the striking similarities between the US economy now and in the lead up to 2008.

Recent moves by the US Federal Reserve to raise interest rates and start to tighten the nation's strongly growing economy may not be working.

In fact, financial conditions across markets haven’t tightened, they’ve actually been encouraged by the Fed's cautious steady pace, and conditions have been easing.

These easier financial conditions have supported both share and debt markets. If this is to continue, there could be an increased risk of current, relatively steady investor sentiment shifting to euphoria.

In March the US central bank lifted its federal funds rate by one quarter of a per cent, into the 0.75 per cent to 1 per cent range. Such tightening of monetary policy traditionally takes some of the steam out of an economy so it doesn't overheat.

Since December 2015, the funds rate has risen by three quarters of a per cent, but financial conditions have only continued to ease.

The Fed had confidence to make these tightening moves as its goals for the US economy—maximum employment and inflation of 2 per cent—are now close to being realised. So it believes it's prudent to start taking action to cool the stimulatory policies it's had in place since the global financial crisis.

The market has been fully expecting these moves. So the economy has not received any disciplinary shock from them. Impact has been further softened by the Fed’s emphasis of the gradual nature of its expected rate hikes, as it works toward a funds rate of 3 per cent in three years’ time. (It, and the market, anticipate two more 0.25 per cent rate hikes in 2017.)

This well-telegraphed, unhurried pace isn't provoking much sense of caution to cool either financial markets or the economy.

We've seen this before

Last decade we saw a similar situation when higher short-term interest rates didn’t tighten financial conditions, though the Fed was steadily raising rates.

Given that such moves are meant to have the opposite effect, how can this be the case? Significantly, the Fed’s gradual tightening was communicated well in advance, and it gave no sign it was interested in really slowing down the economy. Therefore markets reacted positively.

This was evident in the tightening spread between high-yield (ie. high risk) and low-risk government bond yields. The market’s perception of a falling risk environment resulted in credit being made readily available. Credit conditions didn’t tighten until 2008 as signs of a bursting US house-price bubble became evident and the market reacted by pricing in risk again.

Financial conditions being too easy for too long led to what we now know as the global financial crisis.

There is certainly no foregone conclusion that another GFC is on the way. In the 1990s the US was in the same position as outlined above, but then its rate increases did impact the economy, tightening financial conditions, and a mild recession ensued – certainly preferable to a disaster on the scale of the GFC.

The Fed’s slow reaction now reflects low inflation and wages growth in the US, Europe and Japan, along with modest growth in debt outside of the government sector. The deflationary and deleveraging forces of the GFC live on, but there are signs these are fading.

The simple message is if the Fed needs to tighten financial conditions there is still quite a bit of work to do.