Fed should raise rates sooner than later

By Andrew Wilson. This article originally appeared on the Financial Times website, FT.com on September 15th, 2014

If the Federal Reserve plans to take a gradual approach to normalising US monetary policy, it may want to get started soon.

The US economy is improving rapidly. Based on previous experience, the central bank might have already begun to raise interest rates were it not for lingering concerns about the long-term effects of the financial crisis. Looking back at the Fed’s last three major tightening campaigns, conditions today are comparable in many cases and, in some areas, significantly better.

February 1994: The Fed decided to raise rates for the first time in five years. Among other factors, policy makers cited solid gains in industrial production, auto sales and business orders for new machinery and other capital goods. Today, all of these measures have more than recovered from the recession.

June 1999: The Fed began raising rates less than a year after Russia’s default and the collapse of hedge fund LTCM roiled financial markets, citing the easing in financial strain. Today, US financial conditions are as easy as they have ever been, and far more so than in mid-1999.

June 2004: The Fed believed recent increases in inflation were being driven by transitory factors but decided to begin hiking rates anyway, citing the solid economic expansion and improvements in labour market conditions. At the time, year-to-date non-farm payroll growth was about 200,000 per month. In 2014, payroll growth has averaged 215,000 per month. In the second quarter of 2004, the economy expanded 3.7 per cent. In the second quarter of 2014, it grew more than 4 per cent.

Of course, every economic and policy cycle is different, and the current cycle differs from previous cycles in some important ways. In particular, inflation has been low and unemployment remains elevated, suggesting there is still some slack in the economy and the Fed can remain accommodative for longer than previous cycles might suggest. Weak growth in Europe and recent geopolitical turmoil could also restrain US growth.

Still, current Fed guidance suggests the central bank is many months away from initiating rate rises, and plans to proceed gradually after that. While this may be sensible given the circumstances, it does raise the risk that the Fed may later have to move more aggressively than it envisions now. That could create a new set of challenges.

The Fed’s main policy tool right now is its commitment to moving gradually, which has helped to keep interest rates low and financial conditions accommodative. However, considering the economy’s current path, the time for the Fed to at least begin the process of moving rates to more normal levels is drawing near. If that process is sudden and disorderly rather than gradual and well managed, the potential for collateral damage could be much higher.

As last year’s “taper tantrum” illustrated, uncertainty about US monetary policy carries risks. Market volatility spiked and a wide range of financial assets experienced sharp downward corrections. Housing market activity and construction have yet to fully recover from the sharp rise in mortgage rates.

When the Fed signals its first rate hike, a credible commitment to gradual normalisation will be critical to mitigating the risk of another shock. The longer the Fed waits to signal that first move in an environment of improving economic growth, the more the market is likely to question its ability to move gradually, particularly if inflation continues to trend higher. That could mean significant volatility, particularly in areas such as corporate credit and mortgage-backed securities, where sharply higher rates could have real economic effects.

The minutes of the July 29-30 policy meeting suggest a growing number of Fed officials are becoming concerned about the risk of waiting too long.

The Bank of England has raised the possibility that it may need to raise rates earlier in order to maintain a gradual pace of rate hikes over the longer term. The Fed has so far taken a different approach, maintaining its official stance that rates will remain on hold for a “considerable time” after its asset purchase programme ends in October, and that rate hikes will be gradual when they occur.

However, considering the incoming economic data, the Fed may find it difficult to maintain both of those commitments. The best way to preserve the commitment to gradualism might be to move sooner rather than later.

Andrew Wilson is chief executive of Goldman Sachs Asset Management for EMEA and global co-head of fixed income

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