Macro View: 'Perverse' market reaction to Fed rate decision

AFTER the sharp falls recorded in August, share prices have recovered and the financial markets are once again enjoying a complacent mood of calm. But this could prove deceptive.

There is a sense of relief that the worse fears have not materialised. China, although slowing, has not imploded. The emerging markets remain vulnerable, but there has been no major debt default.

Most significantly, the US Federal Reserve has decided not to start raising rates at its September meeting. Although the Fed is still likely to start tightening policy in the next few months, the brief delay underpinned short-term market optimism.

This reaction is a reminder that the markets remain addicted to abnormally low interest rates, and to huge amounts of central bank money provided through QE.

Peverse attitude 

The Fed’s decision not to start raising rates immediately was taken in reaction to heightened global risks, mainly outside the US. But the markets’ enthusiastic reaction to the Fed’s move reflects a perverse attitude, in which additional cheap money more than offsets the risks of worsening growth prospects for the world economy.

The IMF, in line with many private sector analysts, lowered its global growth forecasts for both 2015 and 2016. We also downgraded our forecasts. While the performance of the advanced economies is expected to be satisfactory, albeit mediocre, the IMF cut sharply its growth projections for many major emerging economies, notably Russia, Brazil, Nigeria and South Africa.

Even advanced economies such as Canada, Australia and Japan, which rely on commodities or on exports to China, will grow more slowly than previously predicted.

The IMF’s main conclusion is that downside risks have increased, particularly for emerging markets. This is mainly due to an environment of declining commodity prices, reduced capital flows, pressure on vulnerable currencies and increasing financial market volatility.

The net fall since June in government bond yields in the US, Europe and Japan demonstrates that the markets share this downbeat assessment of growth prospects. While fears of an imminent economic or financial crash have eased, underlying concerns remain unresolved.

Key uncertainties 

The economic outlook in the next couple of years will continue to depend on two key uncertainties. Firstly, how successful will China be in managing the transformation of its economy from excessive reliance on investment and exports, to greater focus on consumer spending? Secondly, will the major central banks be able to edge up interest rates to more normal levels, and to reduce reliance on huge amounts of QE, without unleashing a new downturn? The answers to these questions will not be known for some time.

If the answers are negative, global prospects could be dire and the risks of a new serious recession would escalate. But even if the answer is positive – ie, if China restructures relatively smoothly, and the central banks can implement a successful “exit strategy” – it is unrealistic to expect a return to pre-2008 growth rates. If the transition is successful, we will avoid a new major crash, but growth is still likely to remain historically weak, and the markets will have to adjust to a new and harsher reality.

The US economy continues to expand at an acceptable pace. Though the current recovery is humdrum when compared with previous cyclical upturns, US growth is clearly stronger than in the eurozone and Japan, and is sufficiently solid to convince the Fed that a rise in official interest rates will have to start fairly soon.

US GDP grew at an annualised rate of 3.9% annual rate in the second quarter of 2015, better than expected, slightly up from the previous estimate of 3.7%, and much stronger than the 0.6% annualised rise in the first quarter.

Our full-year US GDP growth forecasts are unchanged, at 2.5% for 2015 and 2.6% for 2016, and recent GDP figures support the perception that the US economy is resilient enough to cope with modest rate increases.

However, a majority of Fed decision-makers concluded that the risks of an imminent tightening are still too high. One reason for this was the inconclusive labour market data. US non-farm payrolls rose by only 142,000 in September 2015, well below expectations, while the disappointingly weak August figure was revised down further.

Although the US jobless rate stayed at a seven-year low of 5.1%, the Fed remains uneasy over weak participation in the workforce, and over the stagnation in September average earnings growth, at an annual rate of 2.2%. Concerns over the adverse impact of higher US rates on the emerging economies will remain a major argument for waiting. Even so, we expect the Fed to start raising rates, albeit modestly and slowly, in December 2015.

Renewed risks

The eurozone recovery continues. In spite of the slowdown in China, the unresolved Greek crisis, and financial market turmoil, the region is now making slow progress Although GDP growth remains lower than in the US, forecasts have been revised up in recent months.

In 2015, we expect the eurozone economy to grow by 1.5%, much better than in the previous two years. However, there are signs that the eurozone upturn is starting to stall, and our growth forecast for 2016 is downgraded slightly.

It is clear that the export-dependent German economy is experiencing major headwinds in the face of the difficulties facing many emerging economies. German manufacturing orders fell 1.8% in August, much below the expected 0.3% increase, mainly due to a drop in foreign demand. Concerns were further heightened by the fact that eurozone annual inflation slipped unexpectedly in September into negative territory, at -0.1%.

Acknowledging the renewed risks facing the euro area, ECB president Mario Draghi stressed that his monetary policies may have to continue to differ fundamentally from those of the US for the foreseeable future. While the main uncertainty for the Fed is when to start the process of edging up interest rates, the fragile eurozone recovery will force the ECB to continue, at least until September 2016, with its current aggressive QE programme. Indeed, if current risks persist, the ECB will not hesitate to increase the scale of its asset purchases, and will extend the existing plan beyond next September.

UK ‘mixed’

In the UK, recent economic indicators have been mixed. The trade and manufacturing figures have been disappointing. Annual UK inflation, which have fluctuated around zero since the beginning of 2015, was -0.1% in September.

However, the September labour market figures were very strong, and wage rises are slowly accelerating. The UK will not tighten policy before the US. But if the Fed starts raising rates in December, we expect the Bank of England to start tightening slowly in the first half of 2016.

David Kern of Kern Consulting is chief economist at the British Chambers of Commerce. He was formerly NatWest Group chief economist