Wondering how the blow out in interest rates is impacting commercial banks, which just happen to have hundreds of billions in duration exposure in the form of various Treasury and MBS securities, not to mention loans, structured products and of course, trillions in IR swap, derivatives and futures? Wonder no more: the Fed’s weekly H.8 statement, and specifically the “Net unrealized gains (losses) on available-for-sale securities” of commercial banks, gives a glimpse into the pounding that banks are currently experiencing. In short: it has been a bit of a bloodbath.
After hitting a recent high of $34 billion in gains three months ago when interest rates were still near 2016 lows, the reported amount of net unrealized gains has tumbled, and from a gain it has turned into a loss of $14 billion as of the week ended December 14. On a 4-week rolling basis, the change amounts to $37 billion in losses, the biggest monthly drop since the 2013 Taper Tantrum.
This may not be the end of it: as the next chart below shows, commercial banks are holding just shy of an all time high of $747 billion in Treasuries and other non-MBS securities, a number which rises to $2.43 trillion if one includes all Treasury and agency securities on commercial bank balance sheets.
Should rates keep rising, the “unrealized” losses will keep building.
Where on the bank income statement do these losses appear? As we explained the last time this was an issue, in the aftermath of the 2013 Taper Tantrum, it comes down to the the Available For Sale (AFS) line, which runs through the Accumulated Other Comprehensive Income line.
It means that the November and December spike in rates will hammer those banks which hold their bond portfolios as AFS, and thus are subject to Mark to Market and ultimately flow through the P&L.
It also means that the shorthand to get a sense of how substantial the MTM losses from bond holdings will be is to look at the massacre that is going on in the AFS line and extrapolate it to all other levered commercial bank (and hedge fund) rate exposure. Expect math PhD-programmed algos that determine the marginal momentum of the S&P to figure this out some time over the next 2-3 weeks once banks begin reporting results which “unexpectedly” are well below expectations, especially since instead of steepening, the Net Interest Margin line has remained very much unchanged, and if anything, has modestly flattened, failing to offset the losses from bank holdings of rate-sensitive securities.
Tag: USA
The End Is in Sight for the U.S. Foreclosure Crisis
The extended period of historically elevated rates of extreme mortgage distress and defaults in the U.S. housing market, better known as “the foreclosure crisis,” has faded from view as the economy continues its slow recovery. A deeper look at mortgage performance data from the Mortgage Bankers Association suggests the crisis has ended in some states, while it is not quite over yet for the nation as a whole. However, the end is near. The condition of current mortgage borrowers considered as a group—nationwide or state by state—is once again comparable to the period just before the Great Recession and the onset of the foreclosure crisis.
As explained below, we identify the fourth quarter of 2007 as the beginning of the nationwide foreclosure crisis; we judge that it had not yet ended as of the third quarter of 2016. Based on current trends, we expect it should end in early 2017. This nearly 10-year nationwide foreclosure crisis will have been longer and deeper than anything we’ve seen since the Great Depression. As many as 10 million mortgage borrowers may have lost their homes.
Some states and regions have experienced severe recessions and housing crises worse than the nation as a whole, while others have suffered less. The result is a wide range of foreclosure-crisis experiences. Among the seven states that make up the Eighth Federal Reserve District, we conclude that only Missouri and Tennessee have exited their foreclosure crises as of the third quarter of 2016 when judged by a national standard; Arkansas likely will follow soon. Meanwhile, Illinois, Indiana, Kentucky and Mississippi may be a year or more away from exiting. If we take into account long-standing differences in mortgage conditions across states, our conclusions are more favorable. Only Illinois has failed to return to its own pre-crisis level and, even there, the end of the foreclosure crisis appears imminent.
Using Data to Define the Start and End of the Foreclosure Crisis
We define the recent foreclosure crisis as the period during which the share of mortgages that are seriously delinquent (90 days or more past due) or in foreclosure in a particular state or nationwide was above the worst level experienced in recent memory (i.e., not including the Great Depression).2 To recognize secular changes in mortgage practices and performance—in particular, steadily rising levels of outstanding mortgage debt and a proliferation of new types of mortgages—we calculate a crisis threshold for the nation and for individual states as the combined rate of serious delinquency plus foreclosure inventory that first exceeds its own five-year moving average by an amount greater than any previously experienced in the data.
We define the end of a foreclosure crisis as the first quarter in which the combined rate drops below its initial crisis reading.
The Foreclosure Crisis at a National Level
Mortgage Bankers Association data show that the U.S. foreclosure crisis started in the fourth quarter of 2007, when the combined rate reached 2.81 percent, a level that exceeded its five-year moving average by 0.67 percentage points, more than any other previous level. Given that the combined rate stood at 3.2 percent in the third quarter of 2016, this suggests that the nationwide foreclosure crisis has not yet quite ended. However, based on the rate of decline in recent quarters, the data-defined end of the crisis on a national scale is likely to occur as soon as the first quarter of 2017. Indeed, comparable data from Lender Processing Services, as shown in the recently released Housing Market Conditions report from the St. Louis Fed, also suggest the foreclosure crisis is nearing its end.
It Has Been a Long, Hard Slog
However it is defined, the mortgage foreclosure crisis will go down as one of the worst periods in our nation’s financial history. For the nation as a whole, the crisis will have lasted almost a decade—about as long as the Great Depression. For most states in the Eighth District, the slightly shorter duration of their foreclosure crises, when measured against their own data trends, has been offset by higher average rates of serious mortgage distress seen even in non-crisis periods.
The conclusion that the foreclosure crisis has been a long, miserable experience for many is unavoidable. And many Americans continue to suffer lasting financial, emotional and even physical pain as a result of their experiences during this time. However, a look at the data today shows that, at least, the end is in sight.
The Fed Admits The Good Old Days Are Never Coming Back
The dots that the FOMC members contribute to the plot indicate their expectations for the federal funds rate.
Technically, it’s what they think rates should be, not a prediction of what rates will be on those dates. Is that a forecast? You can call it whatever you like. I think “forecast” is close enough.
But before we analyze the whatever-you-call-it, let’s look back at the not-so-distant past.
Here’s a rate history of the last 16 years:
I’ve highlighted this fact before, but it’s worth mentioning again: In 2007, less than a decade ago, the fed funds rate was over 5%. So were the interest rates for Treasury bills, CDs, and money market funds.
People were making 5% on their money, risk-free. It seems like ancient history now, but that year marked the end of a halcyon era of ample rates that most of us lived through.
The chart below shows historical certificate of deposit rates—but remember, you could put your money in a money market fund and do better than the six-month certificate of deposit yield, back in 2007.
Today’s young Wall Street hotshots have never seen anything like that. To them, the jump from 0.5% to 0.75% must seem like a big deal. It’s really not. If the chart above were a heart monitor readout, we would say this patient is now dead and that last blip was an equipment glitch.
The point to all this is that these near-zero rates to which we have all adapted are by no means normal or necessary to sustain a vibrant economy.
We’ve done fine with much higher rates before. They are even beneficial in some ways—they give savers a return on their cash, for instance. But there are likely to be consequences once we embark on this rate-increase cycle.
The FOMC cast members are all old enough to remember those bygone days of higher rates as well as I do. So, we would think they might at least foresee a return to normalcy at some point in the future.
Not so.
The FOMC members see nothing of the sort
Here is the official dot plot published by the FOMC. (I have included their preferred heading so that no one complains about my calling it a forecast, even though that’s what it is.)
Each dot represents the assessment of an FOMC member. That group includes all the Fed governors and the district bank presidents. All 17 of them submit dots, including the presidents of districts who aren’t in the voting rotation right now. There would be 19 dots if the two vacant governor seats had been filled.
That flat set of dots under 2016 represents a rare instance of Federal Reserve unanimity: They all agree where rates are right now. (See, consensus really is possible.) The disagreement sets in next year. For 2017, there’s one lone dot above the 2.0% line, but the majority (12 of 17) are below 1.5%.
Nevertheless, it will be a much different year than this one if they follow through. The dots imply that the fed funds rate will rise a total of 75 basis points next year.
Presumably, that would be three 25 bps moves, but they can split it however they want. They could ignore their expectations completely, too. This time last year, the FOMC said to expect a 100 bps rise, or four rate hikes, in 2016. We got only one.
Follow the dots on out and you see that their assessments trend a little higher in the following two years, and then we have the “longer run” beyond 2019. Most FOMC participants think rates at 3% or less will be appropriate as we enter the 2020s.
The most hawkish dot is at 3.75%.
Think about what this means
Today’s FOMC can imagine raising rates only to the point they fell to about halfway through their 2007–2008 easing cycle. They see no chance that overnight rates will reach 5% again. None.
Here is another view of the same data, that shows how the dots shifted.
Looking at each set of red (September) and blue (December) dots, we see only a slightly more hawkish tilt than we saw three months ago. The “Longer Term” sets are almost identical—two of the doves moved up from the 2.5% level, while the two most hawkish hung tight at 3.75% and 3.50%.
That word hawkish is relative here. By 2007 standards, these two voters are doves. But, Toto, I’ve a feeling we aren’t in 2007 anymore.
Inflation, Interest Rates and ‘the Politics of Rage’
Donald Trump will soon be sworn in as president after promising less regulation, tougher trade policies and more government spending on things like infrastructure, which could spur growth. But coupled with tax cuts, such moves could also expand government debt. At the same time, populist pressure similar to what put Trump in office is afoot in England and some European countries, pressing governments to turn inward and spend for the benefit of people who have felt left out by globalization.
Taken together, it looks like a formula that would lead to higher inflation, which in most developed countries has languished at below-average levels since the financial crisis.
In the U.S., a strengthening economy is already leading The Federal Reserve to pledge to continue to raise interest rates. The Fed is targeting an inflation rate of 2% — it’s currently about 1.7% and has been even lower in recent years. This month, the Commerce Department revised up GDP numbers for the third quarter – from 3.2% to 3.5% (annualized) — pointing to faster-than-expected growth.
The Fed’s hawkish stance is a sea change from only a few months ago, when there was much wringing of hands about growth and inflation being too low, says Wharton finance professor Itay Goldstein. “All of a sudden people are talking about infrastructure [spending] and cutting taxes and things that could lead to new growth and growing inflation.”
Politics and Inflation
Mark Zandi, chief economist at Moody’s Analytics, has predicted higher inflation and interest rates, more government debt and slower economic growth under Trump policies, and some other experts warn about the dangers of rejecting trade and international cooperation if the so-called “politics of rage” persist.
While most everyone wants stronger economic growth, some observers worry that anger among voters in various countries about the benefits of globalization could cause some developed countries to turn inward in ways that could hinder economic progress. They point to parallels between Trump’s win and the British vote last June to leave the European union, as well as movements in several European countries that signify disfavor with open trade and immigration policies, and a preference for protectionism and populism.
“Both the Trump and Brexit campaigns evoked fear and anger at immigration, free trade, and globalization and multi-cultureness more generally,” says Dan Kselman, academic director of the IE School of International Relations in Madrid, adding that, “both represent not so much the victory of a political party or a clear political platform, but rather rejection of the status quo political elite from both major parties, seen as corrupt and disconnected.”
If the result of that rejection is policies that favor more government spending on programs popular with the public, economies could grow. But Trump-style policies could be damaging as well, some economists say.
Wharton professor Kent Smetters has said that Trump has talked of reducing tax rates, especially for higher-income people — but also for businesses – that would stimulate the economy in the short run. The Penn Wharton Budget Model shows the impact of various assumptions. “In the short run, it creates some stimulus, but over the long run, you lose a lot of revenue,” said Smetters, a Wharton professor of business economics and public policy, of Trump’s business tax cut proposals.
The risk to the U.S. economy is that the tax cuts will lead the government to increase borrowing and thus further balloon public debt, which could compete with private capital for household savings and international capital flows, depending on whether the overall economy is at full capacity. In the Penn Wharton Budget Model, the short-term gains turn negative over time, and in fact become “very negative” over 10 years, Smetters noted.
Goldstein sees some of the same political and social trends in Europe that won Trump the election in the U.S., with many people thinking globalization has gone too far and that it puts international interests ahead of national ones. “I certainly think it’s a broad phenomenon. It’s not just the U.S. and U.K.,” he says. “There is clearly a backlash.”
Kselman adds, “Donald Trump has promised to repeal the Affordable Care Act, which gave millions of lower class and lower-middle class Americans access to health insurance. He has pledged to adopt traditional trickle-down economic policies, such as the reduction of corporate taxation, that have contributed to increasing American budget deficits, increasing international debt, and the increasing marginalization of the American industrial working class.”
As such, Kselman continues, “Donald Trump’s economic policies are not likely to help the working-class whites who carried him to office.”
US Payments Landscape Changing Fast
From 2012 to 2015, US credit and debit (including prepaid and non-prepaid) card payments continued to gain ground in the payments landscape, accounting for more than two-thirds of all core noncash payments in the United States, according to a Federal Reserve study of U.S. non-cash payments. Automated clearinghouse (ACH) payments grew modestly over the same period, and check payments declined at a slower rate than in the past.
The 2016 Federal Reserve Payments Study, which presents 2015 payments data, found that the number of domestic core noncash payments totaled an estimated 144 billion–up 5.3 percent annually from 2012. The total value of these transactions increased 3.4 percent over the same period to nearly $178 trillion.
Other key findings:
- Card payments grew 19.9 billion from 2012 to 2015, led by non-prepaid debit card payments which grew by 12.4 billion, and credit card payments, which grew by 6.9 billion. Prepaid card payments grew by less than 1 billion.
- Remote card payments, sometimes called card-not-present payments, reached 19 percent of card payments in 2015, an increase of less than 4 percent compared with 2012. Gains in remote cards’ share of total card payments were mitigated by substantial growth of in-person card use.
- Credit card and non-prepaid debit card payments nearly tied for first place in growth by number from 2012 through 2015, both growing by roughly 8 percent over the period.
- The number of general-purpose card payments initiated with a chip-based card increased substantially from 2012, growing by more than 230 percent per year, but amounted to only a roughly 2 percent share of total in-person general-purpose card payments in 2015, during a broad industry effort to roll out chip card technology.
- In 2015, the proportion of general-purpose card fraud attributed to counterfeiting was substantially greater as a share of total card fraud in the United States compared with countries where chip technology has been more completely adopted. Nonetheless, the total share of remote fraud is already substantial (46 percent) compared to its share in total card payments (19 percent).
- The number of ACH payments is estimated to have grown to 23.5 billion in 2015, with a value of $145.3 trillion. ACH payments grew at an annual rate of 4.9 percent by number and 4 percent by value from 2012 to 2015.
- Check payments fell at an annual rate of 4.4 percent by number or 0.5 percent by value from 2012 to 2015. For the first time since the descent began in the mid-1990s, check payments posted a slowing in the rate of decline.
“The data collected for the 2016 study was substantially expanded,” said Mary Kepler, senior vice president of the Federal Reserve Bank of Atlanta, which sponsored the study.
“This reflects an increased desire within the payments industry for additional fraud-related information,” she said. “A limited amount of fraud information was ready for release today, and further results will be released in 2017 as the complete data set is more fully reviewed and analyzed.”
Beginning in 2017, some survey data will be collected annually, rather than every three years, to enhance the value of the study, Kepler added.
“Payment industry participation drives the quality of the study’s results,” Kepler said. “The Federal Reserve appreciates the industry’s response in 2016 and looks forward to working with selected participants for the annual data collection getting underway in the first quarter of 2017.”
US GDP Higher In Q3
Real US gross domestic product increased at an annual rate of 3.5 percent in the third quarter of 2016, according to the “third” estimate released by the Bureau of Economic Analysis. In the second quarter, real GDP increased 1.4 percent.
The GDP estimate released today is based on more complete source data than were available for the “second” estimate issued last month. In the second estimate, the increase in real GDP was 3.2 percent. With this third estimate for the third quarter, nonresidential fixed investment, personal consumption expenditures (PCE), and state and local government spending increased more than previously estimated, but the general picture of economic growth remains the same.
Real gross domestic income (GDI) increased 4.8 percent in the third quarter, compared with an increase of 0.7 percent in the second. The average of real GDP and real GDI, a supplemental measure of U.S. economic activity that equally weights GDP and GDI, increased 4.1 percent in the third quarter, compared with an increase of 1.1 percent in the second.
The increase in real GDP in the third quarter primarily reflected positive contributions from PCE, exports, private inventory investment, nonresidential fixed investment, and federal government spending that were partly offset by negative contributions from residential fixed investment. Imports, which are a subtraction in the calculation of GDP, increased.
The acceleration in real GDP in the third quarter primarily reflected an upturn in private inventory investment, an acceleration in exports, a smaller decrease in state and local government spending, an upturn in federal government spending, and a smaller decrease in residential investment, that were partly offset by a smaller increase in PCE and an acceleration in imports.
Current-dollar GDP increased 5.0 percent, or $225.2 billion, in the third quarter to a level of $18,675.3 billion. In the second quarter, current dollar GDP increased 3.7 percent, or $168.5 billion.
The price index for gross domestic purchases increased 1.5 percent in the third quarter, compared with an increase of 2.1 percent in the second quarter (table 4). The PCE price index increased 1.5 percent, compared with an increase of 2.0 ercent. Excluding food and energy prices, the PCE price index increased 1.7 percent, compared with an increase of 1.8 percent.
Why Trump’s “Border Tax Proposal” Is The “Most Important Thing Nobody Is Talking About”
While the market, and various pundits and economists have been mostly focused on the still to be disclosed details of Trump’s infrastructure spending aspects of his fiscal plan, “one of the least talked about but possibly most important tax shifts in the history of the United States” is, according to DB, House Speaker Paul Ryan’s and President-elect Trump’s “border tax adjustment” proposal.
This is part of the “Better Way” reform package and also figures prominently in the writings of senior Trump administration officials.
What is it?
Put simply, the proposal would tax US imports at the corporate income tax rate, while exempting income earned from exports from any taxation. The reform would closely mirror tax border adjustments in economies with consumption-based VAT tax systems. If enacted, the plan will likely be extremely bullish for the US dollar. What’s more, it would have a transformational impact on the US trade relationship with the rest of the world. Consider the below:
A “border tax adjustment” would, roughly speaking, be equivalent to a 15% one-off devaluation of the dollar. Imports would be 20% more expensive, because corporates would have to pay the new 20% corporate tax rate on their value. Exports would be roughly 12% “cheaper”, because for every $33 of earnings earned from $100 of exports (we use the 33% gross margin of the S&P), there would be a 12% tax cost ($33 earnings*35% current tax rate) that would no longer be imposed on corporates. Taking the average impact on the prices of exports and imports is equivalent to a 15% drop in the dollar.
A border tax adjustment would be very inflationary. The price of exports doesn’t affect the US consumption basket so would have no impact on CPI. However, the cost of imports would go up by 20%, which based on a simple relationship between import PPI and US inflation would be equivalent to a 5% rise in the CPI. Corporates may of course choose to absorb part of the rise in import costs in their profit margins. But either way, the order of magnitude is large.
A border tax adjustment would be very positive for the US trade balance. Similarly to the dollar calculations, a border tax adjustment would be equivalent to an across the board import tariff of 20% and an export subsidy of 12%. Keeping all else constant and applying standard trade elasticity impact parameters to an average of the two estimates results in a more than 2% drop in the trade deficit equivalent to more than 400bn USD, or equivalently, an almost complete closing of the US trade deficit.
In other words, should the “border tax proposal” pass, it would not only send inflation soaring, while eliminating the US trade deficit – a long-time pet peeve of Trump – it would also be the trade-equivalent of a 15% USD devaluation, even as it leads to an offsetting surge in the actual value of the dollar.
To be sure, there are uncertainties related to all estimates above. First, there is a question mark on whether a border tax adjustment based on a territorial corporate tax system (as opposed to VAT) would be allowable under WTO rules. The question is highly complex, but senior Trump advisers have stated they would be willing to take the issue to the WTO.
It is also not clear what types of goods the new tax would cover – the broader the coverage the bigger the impact and vice versa.
Second, the impact on trade highlighted above should be considered an upper bound, as the post-crisis responsiveness of current account balances to relative price shifts has proven to be much lower.
Still, it is hard to argue that such a fundamental shift in tax treatment of US exports and imports would not have a material impact on trade relations and flows with the rest of the world. More importantly, Saravelos argues, the second-order impact of “re-shoring” may be more material given that US corporate activity has been disadvantaged due to the current unfavorable tax treatment of offshore profits.
* * *
Taking all of the above into account, the academic literature is unambiguous in its conclusion that the dollar should rally strongly in the event a “border tax adjustment” is put in place. An appreciating dollar would be a natural response to an improving US trade balance and the competitiveness gains achieved by the shift in the relative prices of exports over imports. In extremis, the dollar would rally by 15% to fully offset the price changes caused by the tax. This analysis is partial however, with the knock-on consequences on the Fed, US corporate off-shoring and global trade relations likely making the impact even more material.
Deutsche Bank concludes that combined with potential changes to the treatment of unrepatriated earnings, “the proposed changes to the US corporate tax code could be one of the most important shifts in US tax and international trade policy in a generation.”
We wholeheartedly agree with DB’s assessment in this particular case.
A Shifting U.S. Policy Mix: Global Rewards and Risks
After a year marked by financial turbulence, political surprises, and unsteady growth in many parts of the world, the Fed’s decision this month to raise interest rates for just the second time in a decade is a healthy symptom that the recovery of the world’s largest economy is on track.
The Fed’s action was hardly a surprise: markets had for weeks placed a high probability on last week’s move. But market developments preceding the Fed decision did surprise many market watchers.
Especially striking were the sharp upward moves in longer-term U.S. interest rates, the dollar, and market-based measures of long-term inflation expectations soon after the U.S. presidential and congressional elections of November 8. No comparably abrupt market reactions preceded the Fed’s previous interest rate hike of December 2015 (see chart).
The dollar has risen further in the days following the Fed’s recent move.
Time will tell if these market developments point to a new trend. Most likely, however, the election marks a shift in the U.S. policy regime with potentially even bigger future effects on prices and activity—abroad, as well as in the United States. Spillovers outside the United States will be felt especially strongly in emerging market economies, where for some, the advantages of enhanced competitiveness due to weaker currencies may be finely balanced against vulnerabilities.
Something has changed
From the start of 2016 and through the U.S. election, Treasury yields had been particularly low. Discussion of the global outlook, including at the IMF, stressed the risks of protracted low growth and continuing deflation pressures—even secular stagnation, with persistently low interest rates.
Longer-term nominal interest rates are, however, strongly influenced by expectations of the future path of the Fed’s policy rate, which in turn responds to U.S. inflation pressures and the economy’s underlying strength. Thus, the sharp post-election turnaround in longer-term U.S. interest rates changed the conversation: it likely reflected not the looming December rate hike alone, which was already widely anticipated, but also a shift in expectations about the future interest rate path and future demand in the U.S. economy.
Consistent with those expectations, while last week’s interest-rate hike was itself not unexpected, the future path of interest rates that Federal Open Market Committee members anticipate also steepened, and now suggests three interest rate hikes in each of the next two years.
The timing of the abrupt asset-price movements—coming within days of the U.S. election—is the key clue about what moved markets. The election of Donald Trump as president, coupled with continuing Republican control of the Congress, ended six years of divided U.S. government.
Implications for the future
Republicans in Congress have long advocated lower personal and corporate tax rates. President-elect Trump campaigned on a platform that included not only substantial tax cuts, but also increases in some categories of government spending, notably defense and infrastructure.
At this early stage, it is hard to know precisely how the shift in fiscal policy will look. One thing seems clear, however: it will turn more expansionary through some combination of more spending and lower tax rates.
In general, any increase in U.S. aggregate demand will generate some rise in real output—as new workers are hired, others work longer hours, and machinery is used more intensively—and some upward pressure on inflation. With the overall unemployment rate at 4.6 percent and other measures of labor market distress largely recovered from the financial crisis eight years ago, there could be little remaining slack in the U.S. economy. Unless labor force participation and overtime work rise significantly, there is a chance that inflation pressure therefore rises noticeably. This seems to be what the Fed has in mind when it predicts it will raise the federal funds rate more quickly.
More rapidly rising U.S. interest rates signal further dollar appreciation. Tax incentives for U.S. corporation to repatriate their past profits held abroad, which some estimate at $2.5 trillion, could also push the dollar up. Given faster demand growth, the outcome will be a widening U.S. current account deficit, that is, more borrowing from abroad. Some of it will possibly finance a growing Federal fiscal deficit, depending on the precise features of the U.S. fiscal package, the extent to which it is paid for by budget cuts elsewhere, the path of government borrowing rates, and the economy’s growth response.
U.S. growth will respond more strongly, with lower inflation, if any infrastructure spending is carefully designed to boost potential output, while tax measures encourage investment, labor supply, and inclusion.
International challenges ahead
Given the United States’ central role in the world economy, big changes in its policy mix have first-order effects beyond its borders.
Advanced economies with currencies that depreciate against the dollar will benefit both from higher U.S. growth and from more competitive exchange rates. For most of these economies, currently struggling with below-target inflation, any resulting inflationary pressure would (at least initially) be welcome. They may also see upward pressure on interest rates, posing a fiscal challenge for countries that are highly indebted but do not benefit enough from the positive demand spillovers that are driving their interest rates upward.
Emerging market economies can also benefit from more competitive currencies and higher U.S. demand. But although many emerging market economies have increased their policy buffers (e.g., foreign reserves), reduced currency mismatches, and improved financial oversight frameworks, some could still feel stress, especially where there are pre-existing political or economic strains.
Historically, U.S. interest rates have been one of the key drivers of net capital flows into emerging market economies. Flexible exchange rates can be helpful as a buffer against rapid outflows, as they allow international portfolios to rebalance through currency changes rather than reserve losses. A combination of rising dollar interest rates and domestic currency depreciation could reduce liquidity or worsen balance sheets, however, especially given the importance of dollar borrowing by residents and non-resident corporates in emerging market economies. Furthermore, currency depreciation might spark higher inflation. Policymakers in emerging markets therefore will remain vigilant.
If sharp exchange rate shifts and growing global imbalances follow the U.S. policy regime change, protectionist pressures become a major risk, as in past similar circumstances. Given the desire of advanced economy governments to maintain manufacturing, where emerging markets have made big inroads in recent decades, it is most likely that emerging market economies are the main targets for higher trade barriers erected by advanced economies.
Governments should therefore keep in mind that protection is likely to be counterproductive at home—even before trade partners retaliate, as they will be tempted to do. The integration of advanced economies into truly global supply chains underscores this danger. In an environment of sharply divergent policy mixes, as we may now be facing, the rules of the global trading system will be more important than ever.
Watch our recent video explaining how interest rates work:
Federal Reserve offers vote of confidence in US economy (so there’s no reason to panic)
No one was really surprised that the Fed raised its target interest rate by one-quarter of a percentage point. Yet some people are really upset about it and worried this will slow down a fragile economic recovery.
I would disagree with that view for several reasons.
My biggest reason is that a quarter-point is not a very big change. I recognize that the economy isn’t yet chugging along at full steam yet, but the Fed acknowledged that by making the smallest increase it could and implying that it’s unlikely to be followed by another increase in January or even in March or May. If we did get another increase that soon, it would only be in response to clear signs of strong economic growth in the U.S.
No magic wand
We should remember that monetary policy is not a magic wand.
Changes like this take time to percolate through the economy and are made with the expectation that their full impact won’t be experienced for several months. What the Fed really said today was that it fully expects that the economy will continue to strengthen over the coming three to six months.
One argument made by those against today’s rate hike (and any others the Fed might be considering) is that there’s still considerable slack in the U.S. labor market. Put another way, our recovery from the Great Recession hasn’t yet reached everyone – meaning a lot of people are still out of work or can’t get the jobs they want – and we should keep rates as low as possible to continue to encourage businesses to expand and to hire more workers.
There’s some merit to this concern. The Bureau of Labor Statistics’ broadest measure of labor underutilization is still at 9.3 percent (including discouraged workers and people who can’t find full-time work). While that certainly sounds bad, this rate was over 17 percent during the worst parts of the recent recession, so we’ve made tremendous progress.
The economy continues to create jobs at a healthy pace – adding 178,000 jobs last month and adding an average of 188,000 per month over the past year. In other words, the Fed is giving our economy a vote of confidence that this level of job creation is likely to continue.
Why a stronger dollar isn’t a concern
Another big concern is that this increase will lead to the dollar getting even stronger in international currency markets.
There are several reasons for the dollar’s rise – most of them have nothing to do with monetary policy. This means that the dollar would continue to strengthen even if the Fed did nothing. One way to look at the dollar’s recent rise is the world is saying they are confident that the U.S. economy will continue to outperform most other regions.
A rate increase is probably a good thing right now because we’ve had the lowest interest rates ever for nearly a decade, and loose monetary policy has probably done about as much as it can for now. It’s not that I think higher rates will be even more helpful, but that I think low rates aren’t likely to help the economy much anymore.
I’d like to see rates return to a slightly higher level so that we have the flexibility to decrease them if needed. In the past, we’ve relied almost exclusively on monetary policy to moderate the ups and downs in the economy and that flexibility isn’t available to us right now.
Some risks
The Fed has certainly heard President-elect Donald Trump talk about his ideas for significant tax cuts and infrastructure investments. Congress has expressed mixed feelings about these proposals, so it’s not certain that they will actually happen. If they do, each of these would boost the economy some, although not right away.
Another reason to raise rates earlier rather than later stems from the beliefs of some economists that loose monetary policy has been a causal factor in several past recessions.
I’m not a strong proponent of this view, but I agree that this potential exists. I’m a more worried about the potential for inflation when banks decide to start using the US$2 trillion they have saved up and deposited at the Fed, but that’s a conversation for another time.
Looking ahead to 2017, a lot will depend on how well the new administration does and how successful they are at getting their proposals through Congress. Assuming the economy continues to plod along, I’d expect another quarter-point increase in mid- to late 2017.
Author: , Associate Professor of Economics, Vassar College
US Mortgage Rates Quickly Approaching 4.5%
Don’t believe anything you read about mortgage rates today… well, except this. In fact, you’re welcome to believe anything you read as long as it acknowledges the fact that rates have risen nearly a quarter of a point from last week, pushing them well into the highest levels in more than 2 years. The average top tier conventional 30yr fixed rate is quickly approaching 4.5%. Nearly every lender that was at 4.125% last week is now at 4.375%. Lenders who were at 4.25% last week are mostly up to 4.5%.
The overall spike in rates since the election is now on par with the 2013 taper tantrum. You’ll hear time and again “don’t worry… rates are historically low…” and my personal favorite “for every .125% in rate, the payment only rises $7 per $100k borrowed.” All of that is true, except perhaps for the “don’t worry” part. Some borrowers may need to worry about no longer qualifying due to debt-to-income guidelines.
Rates haven’t risen a mere .125%, after all. That’s just today’s increase. Added to recent losses, the damage is between .75 and 1.0% now. Let’s take a more average loan amount of $250k and see what happens when the rate goes up 0.75. The increase is over a hundred dollars a month.
Many of the people interviewed by financial journalists have a hard time relating to most of the people that will end up being exposed to their opinions. $100/month may not sound like the end of the world to the CEO of some financial firm, but it is more than enough to tip the scales for prospective homebuyers. They’ll have to adjust their price range at least $20k to get back to the same payment. If that’s not an option for the area, then they’re no longer a prospective homebuyer, or they’ll be forced to move out of the area. This dynamic is not congruent with “not worrying.”
Oh, and you’ll also need to worry if rates will continue to move higher. That’s possible, although for technical reasons, the higher rates go, the more challenging it will be to continue higher. It’s also possible that markets are riding on a cloud of optimistic euphoria and that the cloud will dissipate as the new year begins. It’s possible this rise in rates is a necessary ingredient in longer term trends. In other words, rates have to rise so they can fall again. Last but not least, it’s possible I don’t know everything and rates will go much higher than they are currently, but if that happens, it will increasingly have consequences for the economy.