20 October 2018
Fed chief Janet Yellen is unlikely to push borrowing costs to more normal levels in a hurry, given some still weak spots in the US economy and labor market. Photo: Bloomberg
Fed chief Janet Yellen is unlikely to push borrowing costs to more normal levels in a hurry, given some still weak spots in the US economy and labor market. Photo: Bloomberg

Why the Fed won’t be in a hurry to raise interest rates

Seen from a broad perspective, the US Federal Reserve is unlikely to raise its key interest rate anytime soon. 

Let us take a look at the world’s largest economy. The job market has shown sign of improvement and the unemployment rate has fallen back to 5.5 percent, the lowest since the financial crisis. Total non-farm payrolls increased 295,000 in February and “full employment” is seen achievable.

Nevertheless, the US labor participation rate, which measures the proportion of those aged over 15 years in work or looking for it, dropped to 62.8 percent, down 4 percentage points from the level in early 2007. And the hourly wage has been rising at only 2 percent for long time. That tells a lot about the truth of the job market.

Moreover, as much as 90 percent of the economic data since February has lagged market expectation. Citi’s US economic surprise index, which measures the actual outcomes of economic data releases relative to consensus estimates, has plunged to negative 72 points, the lowest since August 2011. That could be a sign that the US economy has run of out steam.

Also, declining inflation and emerging deflation pressure are also in the way. China, Europe and Japan all have recorded moderating growth and waning demand, and strong US dollar has dragged down commodity prices dramatically. That has weighed on US and even global prices, and given rise to mounting deflation pressure.

In fact, 15 major economies are expected to post a record-low inflation rate of 1.9 percent this year, according to forecasts made by economists and analysts. And the break-even rates have been falling or hovering at low level, which represents a decline in the inflation premium risk.

Meanwhile, yield normalization is easier said than done. Some analysts have noted that the US Federal Reserve has capped interest rate at nearly zero for long time, and it’s time for it to normalize the rate.

However, the historical ratio of three-month treasury yield versus monetary base/nominal GDP shows that if the short-term yield returns to the normal level of 2 percent, the Fed will have to contract as much as 50 percent of its assets, which is equivalent to US$2 trillion and represents over 12 percent of its GDP.

That being said, it’s almost impossible that the US Fed can normalize the yield on its own. Also, other major central banks continue to pump more money into the system.

Most importantly, any rate hike could open a Pandora’s Box, which might lead to the strengthening US dollar going out of control and even trigger a financial crisis.

If the Fed kicks off a rate hike now, the US dollar could become even more stronger given that interest rates in up to 90 percent of the major economies are close to zero. That could spark market chaos and volatility.

And the strong dollar will hurt US corporate earnings and exports, and also accelerate commodity price slide. That would further exacerbate deflation pressure.

Moreover, if the US Fed tightens liquidity, huge amounts of funds will flow out of emerging markets and into the US, and batter the emerging economies. Currencies of a number of emerging markets have already been at multi-year lows recently, reflecting capital outflow from these regions.

This article appeared in the Hong Kong Economic Journal on March 19.

Translation by Julie Zhu

[Chinese version 中文版]

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Hong Kong Economic Journal chief economist and strategist

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