Will history repeat itself ?
«That tighter policy showed its effects straight away as US banks started hiking their borrowing rates while holding down what they pay savers for their deposits – so an immediate boost to bank profits.
Stock markets rose on the news of the Fed hike. That was because investors were relieved that the uncertainty was over and now they knew what was coming and it did not look too bad. They were encouraged by the comments of Fed chief, Janet Yellen, who claimed that the US economy “is on a path of sustainable improvement.” and « we are confident in the US economy”, even if borrowing rates rise.
This was ironic because just before the Fed hiked its interest rate, the figures for US industrial production in November came and they showed the worst fall since December 2009 at the end of the Great Recession. Industrial production and manufacturing output are now contracting at 1% a year rate.
This is partly due to the collapse in energy production as oil prices plummet, but not entirely. It seems that the manufacturing of things in the US is weakening badly, given a strong dollar making exports difficult, and because of low profitability in the productive sectors. It’s true that manufacturing is just 15% of the US economy but growth in this important productive sector has spillover effects into the wider economy, as many ‘services’ depend on manufacturing industries. So a sharp slowdown in this productive sector will hurt.
As former Fed Chair Ben Bernanke explained recently in a moment of clarity, the low real interest rates that Summers is all worked up about are really a product of low profitability. “The state of the economy, not the Fed, is the ultimate determinant of the sustainable level of real returns. This helps explain why real interest rates are low throughout the industrialized world, not just in the United States.”
In the BoE paper, the two economists point out that the rate of return on capital has fallen since the early 1990s, but not by as much as the ‘risk free interest rate’ – so that the cost of borrowing for risky investment has increased by around 100bps. In other words, the cost of borrowing to invest has stayed up while profitability on investment has fallen, squeezing the ‘profitability of enterprise’ and lowering the incentive to invest. The BoE paper refers to the IMF World Economic Outlook April 2014 where the IMF finds that “investment profitability has markedly declined in the aftermath of the global financial crisis, particularly in the euro area, Japan, and the United Kingdom.”
Back in 1937, the US Fed concluded that the US economy had sufficiently recovered then to enable it to start raising interest rates. Within a year, the economy was back in a severe recession that it did not recover from until America entered the world war in 1941. The Fed then had failed to take into account the weak profitability of US capital and its unwillingness to invest for growth. It’s an argument I presented more than a year ago, but it’s still relevant now. Will history repeat itself?»
So the Fed finally bit the bullet and decided to hike its policy rate from 0.25% to 0.50%. It also suggested that it would continue to raise its rate by another 1% point in 2016 and further 1% point in 2017 to reach 3.5% by the end of the decade.
The Fed’s policy rate sets the floor for all borrowing rates in the US economy and further afield for credit in dollars for many economies. So this is an important policy move. It would appear that the era of cheap money, QE and ‘unconventional’ monetary policy is over – at least for the US. The Fed now expects US annual inflation to rise from near zero now to 2% (on its measure of consumer spending) by 2019. That means real interest rates (after deducting inflation) will rise from zero to 1.5%, if these projections hold. That’s clearly a tighter money…
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