US interest rate cycle set to turn
Foryour average central banker, having interest rates at such low levels is not normal, nor does it make them comfortable. The one thing all central bankers fear, to varying degrees, is inflation, with the occupants of the ECB in Frankfurt particularly paranoid on that score.
However, all central bankers have come to realise since the commencement of the ‘great recession’ in 2007 that unorthodox policies would have to be pursued. Unfortunately, the officials in Frankfurt reached that conclusion later than their US equivalents, which goes some way towards explaining the advanced nature of the US economic upturn compared to the European cycle.
The Federal Reserve slashed interest rates quickly once the subprime damage was unleashed. It also launched the unorthodox policy of quantitative easing, which basically involves the creation of new money from nothing, and pumped it in to the real economy, via the banking system, in the hope that it would stimulate some growth. The ECB was tardy in its response, but eventually stepped up to the plate.
The one thing none of us should forget, and particularly borrowers, is that the current interest rate environment is not normal and will not last forever. This week, the US central bank sent its strongest indication to date that it is contemplating tightening interest rate policy. The Federal Reserve has a balanced mandate which involves achieving the best outcome between maximum employment and price stability.
Price stability is regarded as achieving an underlying inflation rate, which excludes volatile items such as energy and food, of around 2%. Mindful of that target, it seeks to push employment as high as possible and unemployment as low as possible without threatening it.
This week, it expressed the view that the economy is growing at a moderate pace; that the labour market is moving towards levels consistent with its mandate; and that inflation is expected to move towards the 2% target in the medium term. All of this is a bit vague, but that is typically how you would expect a central banker to speak.
Sifting through the language, the expectation is that the Federal Reserve could start to move gradually away from its zero interest rate policy as early as September. However, it makes clear that it would not expect rates to rise by very much — it will be gradual and it will be limited, until such time as the economy is much stronger.
It is not obvious how this change in interest rate stance might affect us on this side of the pond.
Given the stagnant nature of the eurozone economy, the persistence of high unemployment, and the fiscal squeeze still strangling many member states, there is no requirement for the ECB to do anything with interest rates for the foreseeable future. So, for those on tracker mortgages, it is nirvana and is likely to remain so for some time. The dollar has already discounted this divergence in interest rates, though it could get a further boost once the speculation becomes a reality.
However, the message that emerges clearly from the US situation is that if or when the eurozone economy shows more meaningful signs of life, in a manner that would threaten its 2% or slightly lower inflation mandate, the inflation-paranoid bods in the ECB will move towards bringing interest rates back towards what it would regard as more normal — around 2% or 3%.
There is no cause for alarm, as such a scenario still seems well away in the future. In any event, the ECB and other EU officials have more than enough on their plate at the moment dealing with the very fluid Greek situation. Economically, I have believed for some time that Greece would and should leave the system but the political arguments across Europe for allowing that to happen are far from compelling.
All this seems trivial, however, as my son’s friend, Jack Halpin, lies in a hospital in Berkeley. Prayers!
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