Fed to introduce alternatives to classic rate hikes, Europe struggles

Published 24.11.2015 01:20

European markets, already sluggish, may be negatively impacted in the aftermath of the Paris bombings and increased U.S. Federal Reserve (Fed) tightening speculation. With Volkswagen's "cheating" crisis widening, European equities have already seen billions wiped off market capitalizations. With "no-growth" and "low-growth" becoming the "new normal" in European economies, investors are increasingly dumping the European common currency, the euro, in favor of the dollar. Meanwhile, the Fed has indicated that it will almost certainly increase rates at its next meeting in December; however, Fed officials have also indicated the need for "new tools" to combat low unemployment and low-inflation.

Europe, currently Turkey's largest trading partner, is in trouble. The euro is at multi-year lows, on-track to trade at parity as early as the year's end. With multi-billion dollar fines and unprecedented recalls in the works for one of its biggest firms, Volkswagen, European equity markets are on edge. Volkswagen alone has already lost nearly $20 billion in market cap year-to-date. The Paris bombings appear to have increased the resolve of the French to fight DAESH in Syria and a broader European coalition may spend billions in combating the terror group. With the aftermath of the bombings and arrests made in connection with the bombings dominating news coverage in Europe, consumer confidence is almost certain to take a hit. With retailers desperate for a better holiday shopping season this year, a confident European consumer is critical for eurozone economies.

As Europe continues to struggle, the United States is singing a more cheerful holiday tune. Although the Fed has expressed an imminent hike in the "Federal Funds Rate" for over a year now, this time it appears to be serious. Nearly every day, a Fed official makes a speech in which they express the December meeting will be the one where interest rates increase for the first time in nearly a decade. In an earlier column, I discussed Fed research that showed the actual "natural rate of interest" to be currently minus 2.1 percent, meaning for the economy to be in a state of equilibrium, the Fed would need to penalize banks and other depositors for parking money in interest-baring accounts. While negative interest rates are hardly a new phenomenon, discussions of "new tools" for central bankers have garnered increased interest as of late.

Federal Reserve Bank of San Francisco President John Williams gave a wide-ranging speech over the weekend that hinted at the Fed's increased appetite for alternative policy making tools. While reiterating a data-dependent approach to timing the first interest rate increase, Williams indicated that December appears to be the right time. I have doubted the Fed's resolve to increase any rates with the U.S. employment participation rate at near 40-year lows; however, this narrative has nearly disappeared from Fed talking points in recent months. The current unemployment rate reflects "full-employment;" as such, the Fed has satisfied half of its two-pronged mandate - the other half being price stability. A low and constant inflation rate is the measure of price stability, according to the Fed, and data indicate that, ceteris paribus, inflation targets will be hit.

As all economists know or should know, markets are continuously in flux. By the next Fed meeting, commodity prices will have continued to fall with oil and precious metals at multi-year lows. This will only continue to depress inflationary pressures. As the euro continues to depreciate against the dollar along with other foreign currencies, the Fed may find inflation projections to be non-existent as the factors of production are suddenly much cheaper.

The culmination of a strong-dollar, low commodity prices and uncertainty going into the U.S. presidential election next year will make December a now-or-never moment for policymakers. In this respect we could see a symbolic gesture of increasing rates while discounting any future rate hikes for the foreseeable future. I would not be surprised if the Fed came up with another way to increase rates while effectively not increasing rates. Look out for a widening of the band, currently at 0-0.25 percent to 0-0.5 percent, which would allow the effective rate to be much less than the top band of the rate corridor. Also look out for an indication of new policy tools in the works that could help stimulate the economy while continuing to keep inflation in check. Turkey appears to be doing well as investors have priced in any rate hikes with the Turkish lira rallying against the dollar, up more than 10 percent from its highs of the year. Look for this trend to continue as the new government and cabinet get to work in Ankara.

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