wage inflation begins to take off, Janet Yellen will have to act by removing the punch bowl from the party. If this happens, sparks could fly in Washington DC, writes Kyran Fitzgerald
America’s top central banker has sent her signal to the markets.
Interest rates are on their way back up, but it is a case of easy as she goes.
Janet Yellen has just announced the second rise in the central bank’s benchmark rate in three months to a level between 0.75% and 1%.
It is only the second time the Fed has raised the rate over a period of seven years.
We are not talking Indy car racing here, no screeching of tyres as the vehicle revs up.
This is gentle stuff. What we are promised is three 0.25% rate hikes this year as the Federal Reserve, in Yellen’s own words, “moves gradually from an accommodative to a neutral stance.”
Another three to four quarter point rises next year are supposed to follow.
Following her announcement, bond yields dipped, a sign that markets have taken the announcement in their stride. The governor has little option but to act with caution.
Any precipitate rise in the cost of money would be an act of madness given the huge levels of debt now swirling around the system at home and abroad.
Some commentators suggest that she is, in fact, being pushed into acting too soon to start raising rates by members of the Trump administration keen on encouraging inflows of capital into the US at a time when the administration is set to embark on a policy of tax cuts and investment in infrastructure.
We live in curious times.
Normally, governments lean on central bankers to keep rates low, but these days the mood in Washington seems to be quite different.
When it comes to monetary and fiscal policy, there seems to be a deep split between those who favour an expansionary fiscal policy recalling the Reagan era and those who favour a soft monetary policy, one designed to restrain any upward movement in the value of the dollar.
A strongly valued dollar threatens to damage the very manufacturing companies that Donald Trump championed in the run up to his election.
In the early 1980s, Ronald Reagan stood by as the then head of the Federal Reserve, Paul Volcker, pursued a brutal counter inflationary strategy.
Between early 1979 and mid 1981, Volcker presided over a rise in the federal funds rate from 11.2% to a staggering 20%.
In the process, inflation which had reached almost 15% in 1980 was squeezed right back down to 3% by 1983. Hundreds of thousands of jobs were lost in manufacturing, particularly in the Midwest.
Thirty years on, many in these very states propelled Donald Trump to the presidency with their votes.
Volcker’s medicine had its own political side-effects.
It ensured that the incumbent, Jimmy Carter lost the presidency in 1980 to Ronald Reagan, paving the way for Reaganomics.
The US eventually boomed under Reagan but at a cost. The national debt expended by 600%.
Janet Yellen comes from a different political tradition. She is a New Dealer at heart, a supporter of Franklin Delano Roosevelt. She is also cautious by nature.
Her task since she assumed office two years ago had been to ensure that the US economic recovery engineered by her predecessor, Ben Bernanke and by President Obama is consolidated and above all, not derailed.
This recovery has itself come at a cost.
It has been brought about in its initial stages by loose money policies which helped to blow up a stock market and asset price bubble.
Those reliant on earnings from savings deposits out of pocket.
The governor knows only too well that act too quickly to reverse policy on rates and you could end up sending frothy markets into a tailspin. Do nothing and you run the risk of repeating the experience of long-serving governor, Alan Greenspan, who allowed a financial bubble to expand to bursting point back in 2007/2008.
Right now, the pressure is off in the sense that while unemployment is below 5%, wage inflation is subdued.
Yellen has thus been allowed time and space to begin a very gradual withdrawal from the expansionary monetary policies that have been a feature of policy making since the financial crisis.
But Trump’s new team threaten to complicate this picture.
The President has just unveiled a broad blueprint in line with his campaign promises.
He promises massive increases in military spending only partially counteracted by swingeing cuts to areas such as foreign aid and environmental protection. A big battle in Congress looms. It remains to be seen how successful the Trump team will be in ramming its ideas through Congress.
However, there is a real risk that fuel could be poured on the flames of recovery. This is pretty much what the stock market is now anticipating. If the traders are disappointed, we can expect a market correction. If there are not then we can expect wage markets to begin overheating, particularly if the promised crackdown on immigrants, key players in the job market, gets under way.
If wage inflation begins to take off, Yellen will have to act by removing the punch bowl from the party. If this happens, sparks could fly in Washington DC.
Oh and by the way, Yellen’s current period of office ends next February. What odds on her reappointment at this stage? It would be advisable not to bet the house on it.
Better to stick the money on horses trained by Willie Mullins or Gordon Elliott.
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