Investors are betting that the Federal Reserve will take its time before pulling the trigger on interest rate rises. Fed insiders warn that this may be a mistake.
By Ambrose Evans-Pritchard
4:49PM GMT 24 Mar 2015
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The US economy will be in full-blown boom by the end of the year and risks overheating unless Federal Reserve lifts interest rates soon, a veteran Fed rate-setter has warned.
“Zero interest rates are no longer appropriate for the US economy. If we don’t start normalizing monetary policy we’ll be badly behind the curve two years from now,” said James Bullard, the head of the St Louis Fed.
Mr Bullard said investors are far too complacent about the pace of monetary tightening and could be in for a nasty shock as the policy cycle turns over coming months.
“I think reconciliation between what markets think and what the committee (FOMC) thinks will have to happen at some point. That's a potentially violent reconciliation and I am concerned about that,” he told a City Week forum in London.
The warning echoes comments this week by the San Francisco Fed’s John Williams, who said the US economy is firing on all-four cylinders. “Things are looking better: in fact, they’re looking downright good. I think that by mid-year it will be the time to have a discussion about starting to raise rates,” he said.
Both men are bell-weather moderates on the monetary spectrum rather than hard-line hawks, indicating where the Fed’s centre of gravity now lies.
Mr Bullard said underlying growth in the US is running at 3.3pc and the unemployment rate is likely drop below 5pc by the third quarter of this year, stoking wage pressures and increasing the risk of a serious error by the authorities.
"With the US economy expected to be going into a boom time there is some risk of an upside surprise on inflation. People have possibly been lulled to sleep in thinking that inflation can’t develop in any circumstance, but that is not what history tells us,” he said.
The latest data shows that the US is tentatively pulling out of deflation after three months of falling prices. The consumer price index rose 0.2pc in February, chiefly due a gentle rise in petrol costs as oil stabilizes.
The 10-year break-even inflation rate – tracked by the Fed as a gauge of expected price rises over the next decade – has jumped to 1.76pc from 1.49pc in January, a clear sign that deflation fears are subsiding.
Rakesh Mohan, the executive director of the International Monetary Fund, said it was far from clear that the Fed would in fact be able to raise rates safely without setting off chaos. “We are entering uncharted waters. Once you are caught in a zero interest rate policy, how can you get out of it without causing a crash,” he told the City Week forum.
Ray Dalio, the founder of Bridgewater Associates, warns that the Fed risks repeating the errors of 1937 when it began to raise rates before the recovery was fully entrenched, precipitating a relapse back into depression. “We don’t know - nor does the Fed - exactly how much tightening will knock over the apple cart,” he said.
Yet the evidence is clear that the Fed will soon pull trigger unless forced to back away by a fresh global shock, potentially an emerging market storm as the soaring dollar tightens the noose on $9 trillion of dollar-denominated debt borrowed outside the US.
Fed officials are deeply irked by accusations that they have been targeting equity prices or that they have allowed the institution to become liquidity prop for Wall Street. Some almost relish the chance to show their teeth again in the fight against moral hazard.
Mr Bullard said the Fed’s decision last week to drop the word “patient” from its plans for raising rates marks a new era in US monetary policy, warning that the central bank is now at liberty to strike at any meeting – though any move in April is effectively ruled out.
He also warned that markets had “badly over-emphasized” the importance of the strong US dollar in shaping in Fed policy, insisting that the headwinds from currency appreciation are overwhelmed by the much greater stimulus from cheap oil and ultra-low bond yields.
The spill-over from quantitative easing in the Europe and Japan has driven US borrowing cost below their natural level – given the current stage of the US economic cycle – and is acting a form of unwelcome monetary easing. Officials say this makes it even more imperative for the Fed to tighten soon.
The dramatic dollar rally has stalled over recent days on signs that US exports are starting to suffer but this may prove no more than a pause to catch breath.
The dollar index (DXY) has risen almost 25pc since mid-2014 – spiking to a 12-year high of 100.3 last week – an even sharper rise than the fierce dollar rally of the late 1990s that set off the East Asia crisis and the Russian default.
“We think the bullish trend for the dollar is still in place,” said Ian Stannard from Morgan Stanley.
“Our bear scenario is that the euro will fall to $0.90 by the end of the year if we see capital controls or anything like that in Greece.”
Mr Bullard said underlying growth in the US is running at 3.3pc and the unemployment rate is likely drop below 5pc by the third quarter of this year, stoking wage pressures and increasing the risk of a serious error by the authorities.
"With the US economy expected to be going into a boom time there is some risk of an upside surprise on inflation. People have possibly been lulled to sleep in thinking that inflation can’t develop in any circumstance, but that is not what history tells us,” he said.
The latest data shows that the US is tentatively pulling out of deflation after three months of falling prices. The consumer price index rose 0.2pc in February, chiefly due a gentle rise in petrol costs as oil stabilizes.
The 10-year break-even inflation rate – tracked by the Fed as a gauge of expected price rises over the next decade – has jumped to 1.76pc from 1.49pc in January, a clear sign that deflation fears are subsiding.
Rakesh Mohan, the executive director of the International Monetary Fund, said it was far from clear that the Fed would in fact be able to raise rates safely without setting off chaos. “We are entering uncharted waters. Once you are caught in a zero interest rate policy, how can you get out of it without causing a crash,” he told the City Week forum.
Ray Dalio, the founder of Bridgewater Associates, warns that the Fed risks repeating the errors of 1937 when it began to raise rates before the recovery was fully entrenched, precipitating a relapse back into depression. “We don’t know - nor does the Fed - exactly how much tightening will knock over the apple cart,” he said.
Yet the evidence is clear that the Fed will soon pull trigger unless forced to back away by a fresh global shock, potentially an emerging market storm as the soaring dollar tightens the noose on $9 trillion of dollar-denominated debt borrowed outside the US.
Fed officials are deeply irked by accusations that they have been targeting equity prices or that they have allowed the institution to become liquidity prop for Wall Street. Some almost relish the chance to show their teeth again in the fight against moral hazard.
Mr Bullard said the Fed’s decision last week to drop the word “patient” from its plans for raising rates marks a new era in US monetary policy, warning that the central bank is now at liberty to strike at any meeting – though any move in April is effectively ruled out.
He also warned that markets had “badly over-emphasized” the importance of the strong US dollar in shaping in Fed policy, insisting that the headwinds from currency appreciation are overwhelmed by the much greater stimulus from cheap oil and ultra-low bond yields.
The spill-over from quantitative easing in the Europe and Japan has driven US borrowing cost below their natural level – given the current stage of the US economic cycle – and is acting a form of unwelcome monetary easing. Officials say this makes it even more imperative for the Fed to tighten soon.
The dramatic dollar rally has stalled over recent days on signs that US exports are starting to suffer but this may prove no more than a pause to catch breath.
The dollar index (DXY) has risen almost 25pc since mid-2014 – spiking to a 12-year high of 100.3 last week – an even sharper rise than the fierce dollar rally of the late 1990s that set off the East Asia crisis and the Russian default.
“We think the bullish trend for the dollar is still in place,” said Ian Stannard from Morgan Stanley.
“Our bear scenario is that the euro will fall to $0.90 by the end of the year if we see capital controls or anything like that in Greece.”
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