The inevitability of tighter monetary conditions

This year begins under a fog of uncertainty that rivals any other in my long association with financial markets. No one knows where politics of populism will take us. The comfortable status quo of globalisation and unfettered capital flows has lifted asset prices to new heights over the past several decades but in doing so also has worsened the gap between rich and poor. For whatever reasons, widening inequality seems to foster a reversion to populist politics and protectionist policies even though history indicates that neither of these frameworks augments the wealth of nations and, if sustained over time, tend to sap a country’s strength and vigour. We now seem to be in the initial throes of optimism about a change in policies, as often occurs in the wake of a US presidential election. Markets are dismissing what they do not know about the future in the hopes that whatever transpires will remedy the shortcomings of past policies. I often refer to this phase of the business cycle as “la la land” for politicians and investors who think fiscal stimulus is a free lunch and asset prices have no upper bound when in reality we are setting the stage for an inevitable tightening in monetary conditions. The only questions are how soon, how much and with what consequences. The Federal Reserve will provide some answers in the months ahead.

The Current Setting for US Monetary Policy

Here is the Fed’s predicament in a nutshell. With the recent spurt in activity, the US economy now is operating on the cusp of its inflation-stable potential. That does not mean that the economy could not produce more output if companies invested more and idle workers accepted new jobs or worked longer hours. Rather, at this threshold the Fed now faces an inevitable trade-off between more growth and more inflation. In the jargon of FOMC members, the Fed has reached its operational targets of 2% inflation and full employment, at which point it must reconsider the wisdom of further monetary stimulus. As long as FOMC members believe the current favourable conditions are sustainable, then they have little choice but to shift policy to a ‘neutral’ stance. Granted, the Fed’s view of what constitutes ‘neutral’ has changed dramatically in recent years. Staff research shows that demographic trends have lowered the equilibrium real interest rate 125 basis points since 1980.1 That implies the new neutral for the fed funds rate now is no more than 50 to 100 basis points, which translates into a nominal funds rate of 2.5% to 3%. The spectre of the Fed being forced to hike short-term interest rates multiple times in the coming years raises key questions for financial markets ranging from what happens to long term interest rates, equity valuations and the viability of the current economic expansion that already is the longest in history.

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