Janet Yellen riddle

To hike or not to hike rates, gets a lot more complicated

A de-growth in US GDP is not great news for Janet Yellen. For her and the other governors of the US Federal Reserve, the decision to hike rates just gets a little more complicated. Wages and inflation are yet to pick up enough to justify a rate hike. And tapering export and GDP is only adding to the problem. There are three major challenges confronting Yellen and team.

Can US monetary policy diverge?

In practice it will be extremely difficult. Year 2008 saw a globally integrated monetary policy for the first time. Back then, most financial markets the world over were extremely fragile in the aftermath of Lehmann. A unified monetary policy was the only way out.

Not much has changed. Today, the problem is low growth. China, Japan, EU, Russia as well as the oil producing countries are showing signs of a slowdown. Every country is following a mix of low rates and liquidity priming to prop growth. Yellen realizes that US cannot really act in isolation.

How to handle asset inflation?

Janet Yellen’s primary concern is asset inflation. Over the last 7 years, near-zero rates and a surfeit of liquidity had ensured that assets like equities, bonds and real estate have all moved one way. Today they have reached a stage when such prices can no longer be sustained with their current or future earnings. But that is easier said than done.

In 2006, the Fed decision to hike rates eventually pricked the sub-prime balloon. Today there is a major froth in the form of overpriced bonds and equities the world over. A sudden rate hike may disturb this delicate balance and create a chaos almost akin to sub-prime in 2007. Janet Yellen would surely like to avoid that.

Can markets handle rate hikes?

This is the million dollar question. First, some interesting statistics! According to estimates, roughly 70% of the US traders were either not in the market or were too junior to appreciate the impact of the last rate hike in 2006. It is not very clear how and whether this majority can really handle a rate hike and its implications for markets. If you look at the last 2 rate hikes in the US i.e. 1999 and 2006, only 5% of the current crop of traders is familiar with 2 hikes. That is a huge risk for markets.

For Yellen, the choice may be between a known devil and an unknown angel. The answer to asset bubbles may be that sectoral bubbles may correct on their own due to extraneous factors. We are seeing that in the case of oil bonds in the US. And the collateral impact and damage will not be huge; so markets can absorb the shock. Probably, status quo may the best choice for the Fed. ©

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