Wednesday’s triggering of Article 50 was a non-event in financial markets; an event more symbolic than anything else. Meanwhile in the US, two Fed officials were discussing their views on what could happen to US interest rates.
The Boston Reserve President said that four rate “hikes” would be appropriate this year, the Vice President of the Fed said two more seemed about right.
What is interesting about these stories, and others like them, is the way this argument is framed. Officials, and market participants, increasingly talk about interest rates in terms of the number of moves, rather than the level. It is now almost a given that moves should come in 0.25% increments.
This is understandable, the vast majority of moves since 1971 have been of 0.25%.
It is also a function of recent experience. Of the 33 rate moves (higher or lower) greater than 0.75%, only 3 have come in the last thirty years (all cuts during the financial crisis).
Eric has discussed how the 1960s and 1970s were an anomalous phase in which monetary policy arguably had a greater role to play and concepts like the NAIRU became tenets of policy making. This week James Montier, who has done much work in the field of behavioural finance, made a similar observation (though many of the arguments would not be shared by all).
And yesterday on Bloomberg TV, Andrew Zatlin (here, at around the 42 minute mark) drew attention once again to this chart, which shows less volatility in the US economy in the last thirty years and implies that there may be less need for the type of large rate moves seen 40 or 50 years ago.
Some may argue that this less cyclical behaviour is because of the success of monetary policy in fine tuning the economy. We, like Zatllin, think it has more to do with decreasing significance of the inventory cycle due to the shift toward a service economy, the role of technology in inventory management, and greater efficiency in the global system. In effect Central Banks may have fallen victim to the illusion of control, taking credit for outcomes that are less to do about monetary policy and more about a structural change in the global economy.
Monetary policy is ultimately a blunt tool for influencing the real economy (especially when it is used in isolation). Many companies and individuals do not borrow at the Fed Fund’s rate or even at a fixed spread over it. The transmission mechanism is too complex for single 0.25% moves to be anything other than noise for most people. Richard Woolnough at Bond Vigilantes has also recently written about how financial conditions have been tightening irrespective of the Fed.
A simple look at yield moves in ten-year US Treasuries shows that around a third of monthly moves over the last ten years have been greater than 0.25%.
When it comes to the real economy then, we should be very sceptical of the ability of Central Bankers to fine tune outcomes. The moves may be just as symbolic as Article 50.
Of course the reason why so much attention is given to minor policy moves (apart from the fact that it is easy to report on because it fits a simple story) is less to do with the economy and more about the potential impact on asset prices. Even symbolic gestures can move prices, while the Fed Funds rate is undeniably an important element of the discount rate on financial assets. However, with so much having been made of Federal Reserve Policy and the potential risks associated with rate increases over the years, investors holding assets without a valuation buffer large enough to withstand small increases can’t say they weren’t warned.