The U.S. Federal Reserve appears about to cede the race to become the first major central bank to tighten monetary policy in the postrecession recovery.
A suddenly hawkish Bank of England Governor Mark Carney moved into the pace position last week when he declared that Britain's first rate hike in seven years "could happen sooner than markets currently expect." With a stronger-than-forecast economic rebound, falling unemployment and Mr. Carney's pointed signal, market participants are now looking at a possible increase later this year, lopping nearly two years off their previous timetable for a dramatic reversal of rock-bottom rates.
The U.S. outlook is also brightening. Although economic growth remains sluggish, the labour market is improving markedly, businesses are signalling plans to do more hiring and increase wages, capital spending is picking up, consumer confidence is on the rise and housing is showing more signs of life. A small business survey shows that optimism has reached levels not seen since September, 2007.
But Federal Reserve Chair Janet Yellen and her voting colleagues on the policy-setting Federal Open Market Committee are in no rush to veer from their current course – particularly with the economic and inflation picture clouded by fresh geopolitical risks that have already led to a sharp increase in oil prices.
When they gather for their next two-day meeting this week, they are likely to reaffirm the current loose monetary policy while sticking to a plan to taper purchases of longer-term Treasury bonds and mortgage-backed securities by a further $10-billion (U.S.) to $35-billion a month. An end to quantitative easing is not expected before the end of the year, and most analysts are not looking for interest rate hikes before the second quarter of 2015 at the earliest, unless unemployment falls sooner to 5 per cent – a level regarded as effectively full employment in the U.S.
The latest data certainly point in the direction of a brighter labour market. The U.S. economy added 217,000 jobs in May, the fourth consecutive month above 200,000 and the first time the number of people bringing home paycheques surpassed the prerecession peak of early 2008. On the down side, the participation rate remained at a low 62.8 per cent. But the jobless rate remained steady at 6.3 per cent and the level of long-term unemployment declined.
All the signs point to "an environment of tighter policy," said Eric Lascelles, chief economist with RBC Global Asset Management, who is forecasting sustained stronger growth for the U.S. economy as a whole, including the addition of 200,000 to 300,000 jobs a month over the next few years. "Oddly enough, though, we don't find ourselves in the end with a more hawkish central bank."
One reason: Central bankers "notoriously get cold feet when they near intended action," Mr. Lascelles said. So the Fed may well wait "for an extra month or two of clarity and confirmation that growth is on."
Policy makers will also have to keep close tabs on geopolitical risks to the recovery story, including the Iraqi crisis and worries about the health of China's financial system. A crisis there would flatten Chinese growth and have a direct impact on recovery prospects elsewhere.
When it comes to reversals of monetary policy, data-loving market historians note that in the past four decades, the Fed has tightened earlier than the Bank of England on three of four occasions by an average of about four months.
But even with signs of sustained U.S. improvement in employment, incomes and spending – key pieces of the puzzle for policy makers – Ms. Yellen and her colleagues are likely to wait on the sidelines longer than might be necessary. That's partly because of concerns that even slightly higher rates could impede the business and consumer spending needed to keep the recovery on track. Ultimately, "this is a central bank that is unwilling or unable to fully deliver on current signals," Mr. Lascelles said.