US gets twitchy as interest rates look set to rise in September

Every remark by Fed chair Janet Yellen, every bit of new data, is crawled over, with the markets making their knee-jerk response

Traders in the New York Stock Exchange with Janet Yellen onscreen in the background (Reuters)

Viewed from the United States, the problems of Greece seem a long way away. Instead all eyes are on the Federal Reserve and, in particular, on its chair, Janet Yellen.

This is a big week for the Fed. On Wednesday Dr Yellen starts her twice-yearly testimony to Congress, first to the House and then to the Senate. It also sees the publication of the so-called Beige Book, which comes out ahead of the meetings of the Fed’s rate-setting Open Market Committee, and which sets out its feelings about the economy. There will not be any change in rates this week, but it looks like a better-than-evens bet that rates will be increased at the September meeting. It will be the first change in rates since 2010, and people are understandably twitchy.

So every remark by Dr Yellen, every bit of new data, is crawled over for a hint about the timing, with the markets making their characteristic knee-jerk response. Last Friday she said that she expected rates to rise this year, then on Tuesday came some soft figures on retail sales. (We have had a rather similar experience in the UK, with Mark Carney saying that he thought an increase in rates was getting closer, followed by those flat inflation numbers.)

The Fed has said that changes in rates will be determined by the economic data, which is common sense because policy responds to what happens to the economy. The trouble with this focus on each little bit of data, however, is that you miss the big picture – the big picture that the US economy, and US economic policy, have both been rather successful.

Remember all that stuff about the fiscal cliff and about a dysfunctional Congress shutting down government? Or the criticism of the cumbersome and distorting US tax system? Those charges are probably quite fair, but I didn’t realise until this week just how quickly the US fiscal deficit was declining, and how fast tax revenues were rising.

The US fiscal year ends on 30 September and the Federal deficit for the first nine months is close to a seven-year low. Over the past 12 months revenues are up nearly 9 per cent, while spending is up by 4 per cent. The deficit last year was 2.8 per cent of GDP and my back-of-an-envelope tally puts it around 2 per cent of GDP this year, which by developed world standards is not too bad at all.

True, they are still arguing in Congress about spending for the next financial year, with the prospect of gridlock again. It looks as though they will have to pass temporary legislation increasing the borrowing cap so that there is not another shutdown of government. So all is not sweetness and light. But this seems to be the way politics works and Europeans have no right to cast stones at US lawmakers given their recent performance in Brussels.

As for the US economy, the great upcoming question is: how will it respond to higher interest rates?

There is a short answer and a rather longer one. In short, it will make no difference because the increase has been so trailed that it is already “in the market”. Indeed, had it not been for the one-off decline in the oil price, with its follow-on impact on US inflation, we would probably have had the first increase in rates by now.

The longer answer starts by acknowledging that ultra-loose monetary conditions have had adverse consequences as well as positive ones. The economy is growing decently and, in that sense, the policies have done the job they were intended to do. But they have also increased asset values, massively in share markets and unevenly but, on balance, substantially in property values. Inequality has risen as a result.

The recovery has also been unbalanced, with unemployment falling impressively – it is now down to 5.3 per cent – but this is as much the result of people leaving the workforce as new jobs being created. There is also an external imbalance, with the current account deficit at 2.6 per cent of GDP and expected to widen a bit more as the strong dollar will tend to cut exports and increase imports. But we have been here before, for people have worried about the US current account deficit for the past half-century and while the rest of the world is prepared to carry on lending to the US, this level of deficit is not a problem. Where else do you want to put your money?

The really interesting question is whether, as the labour market tightens, those discouraged workers will come back into jobs. Labour participation rates are the lowest since the 1970s and no one seems to know why. You can see wages nudging up in areas such as the automobile industry, which is doing rather well at the moment, but there is no general shortage of labour. Far from it. What I think you can say is that there is a resilience in the US that enables the country to adjust both in bad times and in good. If that’s right then this expansion, already running for seven years, can run on.

This expectation of continuing solid growth is the main thing underpinning share prices, themselves a gauge of commercial optimism. But the optimists have to admit that this expansion is, by historical standards, quite mature. There is such a thing as the business cycle and spotting the turning point ahead of time is extraordinarily hard.

But it is hard not to be aware of the general sense that the big picture is coming right. President Obama has just claimed that he has eliminated two-thirds of the deficit. Janet Yellen will presumably be quite upbeat in her testimony to Congress – by the way the Federal Reserve reports to Congress, and there are some political tensions between it and the lawmakers, as you might expect. And if the economy is indeed coming right, then rising interest rates are an inevitable and necessary outcome. So they will be good news, not bad, when they come.