In the short-term, the Fed may need to consider global factors when formulating policy. But over a longer horizon, a greater focus on domestic conditions means that the Fed may go down the road less travelled by raising interest rates from record lows, while European central banks and the Bank of England retain near-zero rates for longer.
Since the UK voted to leave the European Union on June 23rd, there has been growing debate about a possible backlash against globalisation. However, the realm of monetary policy appears to be immune to this trend for now.
Concerns over the effect of the referendum appear to have influenced the Federal Reserve's actions. The last time the Federal Reserve's Open Market Committee (FOMC) met was the week before Brexit. At this meeting, all members voted to keep rates unchanged, including Esther George - the President of the Federal Reserve Bank of Kansas City. Ms George is regarded as hawkish and voted for higher rates at two of the four FOMC meetings earlier this year. She voted to retain status quo in June, citing concerns over the disappointing payroll data that was released in May and the impact of the UK referendum. Other members of the FOMC shared these worries over Brexit, as the minutes stated that the UK's vote "could generate financial market turbulence".
The turbulence indeed materialised. After the referendum, sterling fell to a 30-year low against the dollar. Further declines are likely if the Bank of England (BoE) attempts to use monetary easing to offset the negative impact of Brexit on growth.
On 14th July, the BoE's Monetary Policy Committee (MPC) met for the first time since the referendum. The committee decided to keep rates unchanged, probably because the MPC preferred to wait for tangible evidence of a Brexit-induced slowdown before acting. This evidence is currently limited, but international agencies such as the OECD and the IMF warned that a vote in favour of Brexit was likely to diminish growth.
OECD Economic Policy Paper: The Economic Consequences of Brexit, a Taxing Decision, April 2016
The monetary response to Brexit could lower UK bond yields and depreciate the Pound
Central banks usually react to a slowdown in growth by reducing interest rates. In the BoE's case, the base rate has been at a record low of 0.5% since 2009. The Bank is unlikely to follow in the footsteps of the Bank of Japan (BoJ) and European Central Bank (ECB) by introducing negative deposit rates as these are painful for banks. The UK's banking sector is an important contributor to GDP. However, the BoE has other weapons in its monetary policy arsenal, as it can restart its quantitative easing (QE) programme.
This is likely to push UK bond yields down and make sterling even more unattractive for foreign investors. The currency may also trend lower due to concerns that the UK may now find it difficult to fund its current account deficit, which rose to an all-time high in the last quarter of 2015.
A decline in sterling may push up inflation, but this may be offset by a slowdown in growth in the UK. The chart below shows that markets believe the BoE will prioritise supporting growth over lowering inflation. As a result of Brexit, expectations of higher interest rates in the UK have been pushed back.
Source: Bank of England
Markets also expect interest rates in Europe to remain lower for longer. This is because the UK's decision to leave may be a drag on the Eurozone's fragile recovery and have negative repercussions for the rest of the Continent, if political parties in other countries demand similar referendums.
Flight to safety pushes bond yields into negative territory
These uncertainties have resulted in a rush towards safe-haven assets such as the yen, the dollar and German bonds. In the past, sterling held this status too, but the Brexit vote knocked the currency out of the safe-haven club (at least in the near-term). However, UK gilts still appear to be considered a safe-haven as yields have fallen since the referendum.
This has been echoed by declines in German yields. On July 13th, Germany became the first Eurozone country to auction bonds trading at negative yields. This is the second time a G7 country has issued bonds with negative yields - Japan did so in March. Furthermore, Deutsche Bahn AG became the first non-financial company to issue bonds with yields below zero. Globally, the amount of negative yielding debt around the globe has increased recently.
This makes US Treasuries relatively more attractive, as the US is currently one of the few major advanced economies where government bonds are still offering investors positive returns. The phenomenon of negative yields is unlikely to cross the Atlantic, as financial markets expect the Fed to proceed with normalising monetary policy. The current pause in rate hikes appears temporary, as domestic conditions may tip the balance in favour of higher rates.
As the US economy improves, monetary policy will accommodate in the longer term
The findings from the IMF's recent Article IV consultation with the US stated that the economy is likely to expand at a rate above its potential this year and next. The minutes of the FOMC's June meeting stated that most participants expect inflation to rise to the target of 2% in the medium-term. The statement also noted that a delay in rate hikes was likely to pose risks to financial stability and could result in inflation overshooting the Fed's target. Hence, unless there is a significant deterioration in growth prospects or in global financial conditions, the Fed is likely to start the rate hike cycle before central banks in other major developed countries.
This will mean that global co-ordination of monetary policy amongst advanced economies going forward will be unlikely as the BoE, ECB and the BoJ may need to expand their stimulus programmes. The divergence in monetary policy seems particularly welcome for the BoJ, since a stronger dollar should theoretically lead to a decline in the yen, which would stimulate the inflation that Japan has lacked for several years.
On the other hand, a stronger dollar would be unwelcome for emerging economies as over-leveraged corporates in these countries might struggle to repay the dollar-denominated debts that they accumulated in the years since the crisis when the US implemented quantitative easing. These companies' problems could be compounded, if central banks in emerging economies raise interest rates to prevent currencies from depreciating against the dollar.
In the short-term, the dollar is likely to remain strong, even if the Fed does not immediately raise interest rates. The prospect of Europe turning away from internationalisation has led to jitters in financial markets, which means that investors are likely to favour dollar-denominated assets over those denominated in sterling and euros.
Ironically, this development may imply that the Federal Reserve has to consider global developments when implementing policy in the immediate future. Nevertheless, if domestic economic concerns prevail over a longer period, the central banks of developed countries may decouple from each other just as the UK plans to move away from Europe.