The American economy: Powell position
Could higher interest rates spoil America’s economic boom?
AMENDING a famous metaphor, Janet Yellen once said that the Federal Reserve would “keep refilling the punch bowl until the guests have all arrived”. Last week investors began to wonder if Jerome Powell, who will shortly succeed Ms Yellen at the top of the Fed, might at last deem the party full. On January 29th the ten-year Treasury yield reached 2.7%, the highest since early 2014. The prospect of tighter money caused stockmarkets to sneeze. On January 30th the S&P 500 fell by 1.1%, its biggest decline since August, before recovering a tiny bit the next day. With unemployment low and tax cuts pending, investors are wondering whether inflation and interest rates might soon surge.
The economy grew by 2.5% in the year to the fourth quarter of 2017. According to Okun’s law, a rule of thumb relating unemployment to GDP, falling joblessness explains almost half of this growth. (The unemployment rate fell from 4.7% to 4.1% over the same period.) Early in the year inflation fell short, suggesting that fast growth could continue unabated. But pressure on prices has begun to build. Quarterly core inflation, which excludes volatile food and energy prices, was only just below the Fed’s 2% target at the end of 2017. Markets have recently come to believe rate-setters who say that they will tighten policy three times in 2018 (see chart), as happened in 2017.
The prospect of higher rates has bears worried, for three reasons. First, they think asset markets are not ready for higher rates. On January 29th, before the market wobble, an index of financial conditions compiled by Goldman Sachs, which falls as conditions loosen, touched an all-time low. Postponed rate rises have propelled asset prices in recent years; surprisingly tight policy could have the reverse effect.
The second worry is that consumers are unduly exuberant. In October consumer confidence touched highs not seen in over a decade (it has since fallen back slightly). Purchases of vehicles and parts alone contributed 0.4 percentage points to growth in the fourth quarter. Yet it is not wage growth that is fuelling the spending spree, other than in a few low- and middle-income sectors of the economy. Instead, it is that consumers are saving less. In December the personal-saving rate was just 2.4%, the lowest it has been since September 2005. Were falling asset prices to puncture consumers’ optimism, growth might suffer.
The final worry concerns corporate debt. Last April the IMF warned that indebted firms were exposed to higher borrowing costs. Firms accounting for 10% of corporate assets, they noted, were already struggling to service their debt.
Are these worries reasonable? Asset-price falls are fearsome when people have borrowed too much. But regulatory reforms over the past decade have deterred risky lending. Households may not be saving much, but their balance-sheets are much stronger than before the financial crisis. Corporate debt is a likelier source of trouble, but a rising oil price has eased pressure on indebted energy firms, the most likely to falter. And with bond yields rising globally, the Fed need not worry a strong dollar will destabilise the world economy.
In fact, if Mr Powell can manage the transition to higher interest rates, they will be welcome. The Fed would have more scope to loosen policy during the next recession before rates hit zero. After all, the worst thing that can happen to a party is for the punch bowl to run dry too soon.