Foot Of The Hill

16/03/2012 at 12:07 pm

Yesterday afternoon, the following three items topped the list of worldwide headlines on the Bloomberg terminal:

  • Initial Jobless Claims in U.S. Declined Last Week to Match a Four-Year Low
  • Wholesale Prices in U.S. Rose by Most in Five Months on Higher Fuel Costs
  • New York Area Manufacturing Expanded in March by the Most Since June 2010

There, in three lines, was a neat overview of the US economy: strengthening recovery, growing employment and rising prices.

Now compare this to the so-called “dual mandate” of the Federal Reserve, which as well as inflation is supposed to keep an eye on unemployment. As detailed on its website:

The Congress established the statutory objectives for monetary policy – maximum employment, stable prices, and moderate long-term interest rates – in the Federal Reserve Act.

In practical terms, maximum employment is taken to mean an unemployment rate of 5.2-6% and price stability to mean 2% inflation in the personal consumption expenditure component of GDP. Nobody talks much about the “moderate long-term interest rates” part (though technically as we see the Fed actually has a “triple mandate”). But – just for fun – if we look at the 10-year US government bond yield, it has averaged a shade under 5% for the last twenty years. It now stands at 2.3%.

This is of course down to the emergency monetary policy framework that has been in place for over three years now and that has among other things seen the Fed’s target rate set close to zero and substantial intervention in government bond markets by the central bank.

Over recent months, however, the unemployment rate has fallen from a high of 10% to 8.3%, and this week’s continued strength in the jobless claims numbers suggests further falls to come. In other words, the rate is about half way between its 2009 peak and the 6% level identified by the Fed itself as being consistent with its mandate to accomplish “maximum employment”.

Similarly, the rate of inflation attaching to personal consumption expenditure was measured at 2.4% on the year to January, a little higher than the long run 2.1% average (and the 2% level recently settled on by the Fed).

The obvious question is: with growth, price behaviour and employment consistent with or returning to normal levels, for how much longer will monetary policy remain the odd one out?

In recent statements, Fed Chairman Bernanke has emphasised the employment part of the central bank’s mandate, remained very guarded in his assessment of the US economy and affirmed the Fed’s view that near-zero rates will be with us until late 2014. Futures markets are no longer quite so dovish, pricing in a 50bp increase or so over the next two years.

Obviously Mr Bernanke doesn’t want to frighten the horses. But with the US economy behaving as it has done in recent months, 2014 seems a long time to keep interest rates at their lowest ever levels.

The average target rate for the Fed over the last twenty years, to the nearest quarter point, is 3.25%. It’s not an especially high level. It is, however, very far from being priced in by markets over the next few years, and from where we stand today the increase required to get back there looks like quite a climb.


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