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The US Federal Reserve is the most important central bank in the world. And that’s because the US economy is still the most important economy in the world.
The US is 28 per cent of world GDP. That compares with the European Union, which is about 21 per cent, and China, which we hear so much about, is only a bit over 5 per cent.
So world interest rates are really made by the Federal Reserve.
Perhaps the clearest exposition of how the Fed makes monitory policy was given five years ago by the then chairman of the Federal Reserve, Alan Greenspan.
He talked about the economy in the following ways.
He said what the Fed has to do is, is it has to look at not just inflation like the European central bank, but it also has to maximise employment growth.
Employment growth, he said, in the US economy is driven by investment growth.
And what drives investment growth is two things.
Firstly, the rate of growth of profits in the US economy and the hurdle rate. And the hurdle rate is the hurdle rate that faces US corporations making investments.
The hurdle rate, he said, is made up of two things. One is the risk premium and then the riskless rate.
The Federal Reserve fed funds rate is the riskless rate and the risk premium is the uncertainty that companies face in investing in the economy.
Now in 2001 during the recession of that period Greenspan said the risk premium increased and that meant that the whole hurdle rate increased.
So that meant that at a given state of profits, companies had a higher hurdle rate, therefore they invested less and the result of that was that employment growth slowed down during the recession.
And Greenspan said that the remedy to that is to cut the riskless rate - that is to cut the real fed funds rate - to a point where the combination of a much lower riskless rate and a bigger risk premium because of uncertainty means that the whole hurdle rate falls.
And when you do that at a given level of profits, companies will invest more and therefore that will generate a higher level of employment growth.
So what happened during the recession of 2001/2002 is that the Fed aggressively cut the fed funds rate. And it cut it from 6 percent all the way down to 1 percent.
That reduced the hurdle rate, therefore companies invested more, there was a boom in employment and the US economy grew its way out of the recession of 2002.
Right now, what we’ve seen at the end of 2006 and the beginning of 2007 is that the Fed is keeping rates on hold and the result of this is that inflation very slowly is beginning to decline.
If we look at those indicators of where the Fed should take monetary policy in the next quarter say, or in the next two quarters, what we can see is that investment growth is slowing very slightly and profit growth is slowing very slightly.
This isn’t enough to generate a cut in the fed funds rate - it is enough to keep rates exactly where they are.
At the same time though the Fed is talking tough on inflation. This doesn’t mean it’s going to put up interest rates, it’s engaging in what the market calls open mouth operations.
It’s attempting to make the long-term yield curve or the bond market reflect increases in interest rates it’s already done.
I’m confident that the Fed will be effective in those open mouth operations in forcing up long-term interest rates.
But we will get to a situation by the end of calendar 2007 where we will see a significant slowdown in investment in the US economy and we will see a significant slowdown in profit growth.
At that point, and only then, the Fed will start to cut interest rates.
This is Michael Knox.
The US is 28 per cent of world GDP. That compares with the European Union, which is about 21 per cent, and China, which we hear so much about, is only a bit over 5 per cent.
So world interest rates are really made by the Federal Reserve.
Perhaps the clearest exposition of how the Fed makes monitory policy was given five years ago by the then chairman of the Federal Reserve, Alan Greenspan.
He talked about the economy in the following ways.
He said what the Fed has to do is, is it has to look at not just inflation like the European central bank, but it also has to maximise employment growth.
Employment growth, he said, in the US economy is driven by investment growth.
And what drives investment growth is two things.
Firstly, the rate of growth of profits in the US economy and the hurdle rate. And the hurdle rate is the hurdle rate that faces US corporations making investments.
The hurdle rate, he said, is made up of two things. One is the risk premium and then the riskless rate.
The Federal Reserve fed funds rate is the riskless rate and the risk premium is the uncertainty that companies face in investing in the economy.
Now in 2001 during the recession of that period Greenspan said the risk premium increased and that meant that the whole hurdle rate increased.
So that meant that at a given state of profits, companies had a higher hurdle rate, therefore they invested less and the result of that was that employment growth slowed down during the recession.
And Greenspan said that the remedy to that is to cut the riskless rate - that is to cut the real fed funds rate - to a point where the combination of a much lower riskless rate and a bigger risk premium because of uncertainty means that the whole hurdle rate falls.
And when you do that at a given level of profits, companies will invest more and therefore that will generate a higher level of employment growth.
So what happened during the recession of 2001/2002 is that the Fed aggressively cut the fed funds rate. And it cut it from 6 percent all the way down to 1 percent.
That reduced the hurdle rate, therefore companies invested more, there was a boom in employment and the US economy grew its way out of the recession of 2002.
Right now, what we’ve seen at the end of 2006 and the beginning of 2007 is that the Fed is keeping rates on hold and the result of this is that inflation very slowly is beginning to decline.
If we look at those indicators of where the Fed should take monetary policy in the next quarter say, or in the next two quarters, what we can see is that investment growth is slowing very slightly and profit growth is slowing very slightly.
This isn’t enough to generate a cut in the fed funds rate - it is enough to keep rates exactly where they are.
At the same time though the Fed is talking tough on inflation. This doesn’t mean it’s going to put up interest rates, it’s engaging in what the market calls open mouth operations.
It’s attempting to make the long-term yield curve or the bond market reflect increases in interest rates it’s already done.
I’m confident that the Fed will be effective in those open mouth operations in forcing up long-term interest rates.
But we will get to a situation by the end of calendar 2007 where we will see a significant slowdown in investment in the US economy and we will see a significant slowdown in profit growth.
At that point, and only then, the Fed will start to cut interest rates.
This is Michael Knox.
