Is the Fed making a lone stand?

The controversies of a widely-anticipated rate hike

As expected, the Fed raised its base rate this week for the second time this year. This widely-anticipated rate hike is justified by the flourishing health of the US economy. With Q2 growth forecast at 3% and the unemployment rate at an all-time low, with inflation still close to 2%, the Taylor rule estimates optimal base rates at 5%, far above the current 2% level. Maintaining monetary normalisation on track therefore seems to be a given. As such, the Fed could hike rates twice more this year to 2.50%.

As usual however, monetary policy triggers controversies.

Firstly, the US yield curve is flattening-out dangerously. The spread between 2-year and 10-year rates recently reached 40 points. As Fed Governor Lael Brainard recently pointed out, there has only been one single case since 1960 when an inverted yield-curve has not preceded a recession. Under the Fed’s median forecasts, the curve would invert between 2019 and 2020. This context may encourage the Fed to try to further steepen the curve by providing more symmetrical guidance regarding its inflation target. The target could be maintained at 2% throughout the cycle, while authorising downticks and upticks. Such a shift in tone would cause inflation outlook to drift. The second controversy does not concern the US. Can the Fed increase interest rates alone, while the rest of the world’s central banks maintain their rates at historically low levels? Neither the ECB, nor the central banks of Sweden, Norway, Switzerland, Australia and New Zealand, or the Bank of England, have reacted to the rate hikes implemented by the Fed. Even the emerging economies are maintaining historically low monetary rates and very few countries have begun monetary normalisation. Against this backdrop, the dollar rally and the rise in US rates could jeopardise global growth. Although monetary policy is therefore likely to continue to normalise in the US, the minutes published after the Fed meeting will have to be closely scrutinised, as it cannot be ruled out that the Fed, under Jerome Powell, slightly adapts its reaction function.