The markets have reacted with muted disbelief at Janet Yellen’s words. She touched upon the possibility of a policy alteration, albeit with a number of caveats attached: robust growth in employment figures, rising salaries and an inflation rate closing in on its medium term target.
None of the above may materialise in the short run, in particular, the upswing in price levels. Low-interest rates in the medium and long-term suggest dwindling expectations for inflationary bouts. Thus, the markets are betting that the FED will take low-key measures after the summer break.
Moreover, the steep rise in the dollar weighs heavily against an aggressive rates policy. In such a mild scenario, bonds and shares will likely maintain their buoyant mood. Investors might prove utterly overconfident. The FED has signaled its will to act and only an unforeseeable worsening of economic conditions could stop it. Should it move by June, it might take another go before the year-end, thereby fooling the markets.
The sheer liquidity glut also invites the FED to take action now before it becomes too late. It is deeply concerned at the prospect of losing control should the economy increase its growth rate. It also badly needs to reaffirm its independence which is being openly challenged by the Republican majority. Thus, we are headed for a new era of tightening after six years of extensive liquidity.
This huge change in the US monetary stance will have lasting consequences worldwide. As risk aversion unfolds, it will put pressure on emerging economies leading to lower growth rates and currency shocks. Europe will no longer benefit from historically low interests in longer maturities. We will import the US hikes, facing stiffening credit conditions. No one will escape the shock waves stemming from the switch in FED policy.
The move is likely to gather pace over the next few years. Some analysts believe that US rates could climb to over 3.5% in 2017. Others are more cautious and put that figure at no more than 2%. Whatever the outcome, markets are bound to experience a bearish period in the future. Such a shift in sentiment seems the only way to slowly wipe out the excess liquidity embedded over the past number of years.