Monetary Policy And Rates. You Must Understand Money Flow

Over the years, it's become essential (to me) to understand monetary policy and money flows across the globe. With all of the recent 'pining' over whether the Fed will begin to raise rates this year, I felt this piece from Financial Times gave a great representation of who is worried over what, and why.  I truly recommend you give if it a read.  There's also more discussed on this article.  Enjoy.

Why is the Fed considering raising interest rates now?

America has seen its longest private sector hiring spurt on record, and unemployment has halved since its peak. The Fed thinks the hot jobs market could spur a pickup in inflation and wages. Given it is tasked with keeping inflation low, it is considering raising the cost of borrowing to keep the economy on an even keel.

Why have rates in the US been held so low for so long?

The US was hit by the crash in its housing market and banking sector between 2007-09. The Fed felt it needed to pull out all of the stops to prevent the economy from collapsing into a new Great Depression. One way of keeping things afloat was by cutting the cost of borrowing to rock-bottom levels.

Is the US economy ready to cope with interest rate rises?

That is the trillion dollar question - and opinions vary widely. To optimists, the Fed has managed to engineer a respectable recovery that is outshining many other economies. They say a quarter-point increase would have a negligible impact but is a sensible first step to ensure the Fed stays ahead of inflation. Sceptics warn that inflation remains on the floor and the Fed risks roiling world markets and pushing up the dollar if it acts too soon.

How fast are rates likely to rise?

Not fast at all - if the Fed is to be believed. One of the mantras adopted by Chair Janet Yellen this year has been that rate rises will be gradual. The pace of increases - when they begin - is expected to be less than half the tempo of the Fed’s last round of rate rises, which started in 2004. And the ultimate rate they stop at is likely to be very low too, at not much more than 3 per cent.

Federal reserve interest rate predictions from June 2015 meeting

Will they return to the levels seen pre-crisis?

Not for the foreseeable future, according to Fed policymakers’ own projections. The Fed believes the rate compatible with stable growth and prices has sunk sharply because of the lingering effects of the crisis and will increase only gradually. In this subdued post-crisis world, the central bank will need to keep its foot on the accelerator for some time to come.

How does a rise in central bank interest rates get transmitted to the wider economy?

Adjusting the federal funds rate - the rate banks charge each other for short-term loans - affects other short term rates paid by firms and households. These movements also have knock-on effects on long-term rates, including mortgages and corporate bonds. Changes in long-term rates will have an influence on asset prices, including the equity market. During the crisis the Fed also purchased longer-term mortgage backed securities and Treasury bonds to lower the level of long-term rates.

US Business

Are businesses ready for an increase in borrowing costs?

Many corporations have taken advantage of the low rate environment to borrow money via the bond markets. Most companies say they are relaxed about the impact of a small rate hike, believing the market has already priced their bonds or such an event. However, some economists say the interest payments for companies who have issued low-grade debt could rise more quickly.

What are zombie companies and why are we concerned about them?

Zombie companies are enterprises that have been able to stay in business primarily because of the persistence of ultra-low interest rates, and which would be unable to survive a rate hike. Many of these companies will go under when their borrowing costs rise, but some, such as “bond king” Bill Gross, think this could be a good thing. They argue that when weak companies file for bankruptcy, their owners and employees often go on to work for more successful ventures, which is ultimately a good thing for the economy.

US Consumers

What will a rate rise mean for my personal finances?

An upward move in short-term interest rates will be positive for savers who have been missing out on interest on their deposits. But the change could also be transmitted to a range of other interest rates, including car loans, credit cards and mortgages, which would make them more costly.

Are US consumers in general prepared for rates to rise?

The burden of household debt has fallen since the crisis, reaching 114 per cent of net disposable income last year, according to OECD statistics, suggesting consumers are better prepared for higher borrowing costs. In addition, a quarter-point hike would still leave rates at historically low levels.

Financial Markets

How will investors react to higher US interest rates?

This is the hottest and most disputed question in markets today. Some say the Fed has telegraphed a move so clearly that markets will take any interest rate increase in their stride. Others fret that some turbulence is inevitable after seven years of “ZIRP” - zero interest rate policy - and trillions of dollars worth of bond-buying by the US central bank.

How are currency traders positioning themselves in the anticipation of rate rises?

Currency markets are fickle, but differences in interest rates tend to drive movements in the longer-run. For example, if a European investor can borrow cheaply in Berlin and buy a higher-yielding US bond, then all else being equal the dollar will rise versus the euro. As a result, the dollar started the year in rip-roaring fashion, with an index measuring the US currency against a basket of its peers rocketing to a 12-year high, as investors bet on the Fed tightening monetary policy and bond yield differences widened.

Since then it has continued to beat up emerging market currencies but the broad rally has fizzled out as the euro and the Japanese yen have regained their footing. However, many analysts and fund managers expect the greenback to continue to climb higher in the coming years, as the Fed raises interest rates further.

What investments are most sensitive to interest rate rises?

Almost every asset class on the planet exhibits some evidence of frothiness these days, but some seem more vulnerable to higher interest rates. Although stocks look expensive, higher interest rates indicates that economic growth is firm, and that is good for listed companies. Gold typically loses its shine when interest rates climb, as the metal doesn’t pay any interest like a bank account will, but has already been beaten up heavily recently. The bond market looks more exposed. Highly rated debt is trading with very low yields, which means they are vulnerable to even a modest rise in Fed interest rates, while bonds issued by companies rated “junk” could suffer if more expensive borrowing tips some weaker groups into bankruptcy.

How does the recent China turmoil affect the Fed’s decision?

In theory, the Fed makes its decision on raising rates based on its appraisals of domestic economic issues. However, with emerging markets accounting for 39 per cent of global GDP in nominal terms and 52 per cent in purchasing power parity terms, a US monetary policy that enfeebles emerging markets risks depressing global demand and therefore impacting US growth further down the line. This is particularly the case with China. In a specific sense, a Fed rate hike runs the risk of increasing the attractiveness of US-dollar assets relative to those denominated in renminbi, thus accelerating capital outflows from China and leaving Beijing with fewer resources to invest in US Treasury debt.

What about the UK?

Will the UK automatically follow the US in raising rates?

There is no automatic or formal link between US and UK interest rates but the widespread expectation is that the Bank of England will be the next central bank after the US to raise rates. The UK’s economic recovery is well on track, with solid growth and a strong labour market.

The Bank of England typically follows the Federal Reserve's lead

Historically, US and UK market interest rates, as measured by government bond yields, have also moved in tandem. These are the rates, set by the financial markets that feed down into the real costs of borrowing for households and companies.

Bond yields move in tandem

What are we expecting from UK interest rate rises?

Bank of England governor Mark Carney has stressed that while the next move in rates is likely to be upwards, the path of increases will be “limited and gradual”.

While refusing to be drawn on precise timing, Mr Carney said the decision of whether to start lifting rates was likely to come into “sharper relief” around the turn of the year. Analysts are not predicting the first rise until February at the earliest, with many pushing the timing back into the late spring.

The rest of the world

Are all major central banks around the world thinking of raising interest rates?

No. The Bank of England is widely expected to follow the Fed and raise rates, most likely some time in the new year. But as the prolonged weakness in oil prices continues to keep inflation low, many central banks in the rich world are expected to loosen monetary policy further, for example expanding their programmes of quantitative easing. Mario Draghi, president of the European Central Bank, paved the way for an extension of QE last week and the Bank of Japan may well decide to go the same way to bring inflation back to target. In China, the central bank may also cut rates further to stimulate growth. The outlook for emerging markets is harder to gauge: were a Fed hike to trigger turmoil across Africa, Asia and Latin America, countries there may choose to cut rates to help the economy, or increase them in order to dissuade investors from taking their money abroad.

Why would a rate rise in the US impact the emerging market countries?

We have already seen the antecedents of the main impact: a stronger US dollar, backed by higher US interest rates, tends to depress the values of emerging market currencies at a time when many EM economies are already weakening and their currencies have already slumped against the greenback.The Fed’s rate rise could exacerbate the EM currency turmoil, and even help precipitate a full-blown crisis.

Jargon buster

What is tightening and loosening?

When a central bank “loosens” or “eases” policy it essentially increases the supply of money in the economy and pushes down the cost of borrowing. This could be by lowering interest rates, or buying more assets with the aim of putting more money into circulation and encouraging greater economic activity.

“Tightening” is the opposite. If policymakers worry that an economy is begin to overheat, potentially generating too much inflation, they can tighten policy – such as raising the interest rate they charge banks to borrow from them, to make the cost of credit more expensive.

Changes to interest rates can take-up to 18 months to feed through into the real economy.

What is monetary policy?

Central bankers control more than just interest rates. “Monetary policy” is a broad brush term for a whole range of actions, including things like selling or buying assets such as government bonds, raising or reducing the amount of capital banks need to hold against liabilities, and raising or lowering interest rates.

All of these actions impact the cost and supply of money in an economy which are the main levers central banks use to try and keep inflation at its target level and the economy growing at a sustainable speed.

Changes in monetary policy can take-up to 18 months to feed through into the real economy.

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