Yellen to Trump: This is your mess now, Mr President
The US Federal Reserve has finally managed to squeeze in a solitary 2016 interest rate rise.
That's no big deal. Everyone was expecting it.
But they weren't expecting what came next...
The Fed finally raises rates
Around about this time last year, the Federal Reserve raised interest rates for the first time since the financial crisis.
At that point, judging by the Fed's forecasts, everyone in the market thought that there would be four more quarter-point rate rises during 2016. By now, rates would have been above 1%.
As it stands, that didn't happen. Markets kicked off 2016 by panicking badly. China's stockmarket tanked, Japan took interest rates negative, and suddenly everyone was worrying about another 2008, or at least about a wave of deflation swamping the world again.
So the Fed spent most of the start of the year undertaking a massive U-turn. By spring, the Fed had pulled back from the idea that it would raise rates by much if at all. Markets duly recovered.
Then Brexit came along. Cue another deflation scare, with bond yields hitting the lowest levels on record in July.
When it turned out Brexit (or the promise of it, at least) wasn't all that bad, it was getting too late in the political calendar for the Fed to bother doing anything. It was the run-up to the US election. It couldn't be seen to interfere.
All in all, all through 2016, there was always a good excuse to keep rates low. Particularly for an institution that – since Alan Greenspan's reign – has never been a big fan of tightening anyway.
That is, until last night. The Fed decided to raise rates by a quarter point again. Now the US Federal Funds rate stands at 0.5% to 0.75%.
That's not a huge surprise. It would have been pretty tricky not to raise rates. The market was virtually certain that another rise was going to come this month. Stocks are soaring. Everyone is excited about Donald Trump's apparent plans to slash taxes and spend fortunes. As far as the market's concerned, Trump is still all upside and no downside.
However, there was one big surprise. And it points to turbulence ahead.
The Fed now thinks that there will be three more rate rises in 2017. That may not sound like a big deal, but it's much punchier than the market was expecting.
Bear in mind that the market is used to the Fed constantly reassuring investors that there is not much need for tighter monetary policy. Generally, the Fed is more "dovish" than investors expect.
So this is a bit of a turn-up for the books. Fed boss Janet Yellen downplayed the significance of the revised forecast. But markets haven't taken it that way.
The dollar – already strong – has risen even further this morning. US bond yields have risen strongly, suggesting markets expect rates to rise more rapidly. The "spread" (ie the difference) between US bond yields and German bond yields has hit a high not seen since 1989 (the year the Berlin Wall came down), as Michael Hewson of CMC points out.
I think markets are right to take this seriously. This could be a significant shift. Here's why.
Yellen to Trump: this is your mess now
As I've explained many times here before, Yellen is guided by the same rough principles as her predecessor, Ben Bernanke. They both believe that the Fed caused the Great Depression of the 1930s by being too tight with monetary policy.
If there's one mistake that they want to avoid, it's over-tightening and causing another depression. That would be very embarrassing.
So until now, Yellen has been keen to go easy on markets, to keep things ticking over and to emphasise that she really wants to see inflation taking off before she even thinks about raising rates.
That sense of caution was gone last night. Yellen sounded both more bullish on the economy, and more keen to deny that the Fed would risk getting behind the curve, than she has in the past.
So what's changed? Has the US economy miraculously got a lot healthier in the past month? Nope – it's doing fine, but it has been all year. Has the US dollar – whose strength was terrifying markets earlier this year – suddenly got weaker, and become less of a threat to global markets? Nope – it's at its highest levels since 2003.
The only thing that's really changed is that we have a new president-elect who has been pretty hostile to Yellen, and who claims he's going to "make America great again".
This is all about Trump. And I don't think it's because he advocates higher spending (bear in mind that Hillary Clinton wanted higher spending too, though getting it past the Republicans would probably have been harder for her). I think it's because Yellen now considers the economy to be his problem and responsibility, not hers.
It's almost as though she's thinking: "You want higher rates, Mr President? Fine. It's your call." And if that does cause the next Great Depression, she can blame him.
In the future, when she's sitting at a dinner party with Ben Bernanke and Larry Summers, they won't say to her: "How could you have made the same mistake as we did in the 1930s?". Instead, they'll commiserate and say: "What choice did you have? You tried your best. It was all that blowhard buffoon Trump."
Does that sound weird to you? Maybe it is. But economics is all about people and incentives. Incentives aren't always financial. With the election of Trump, Yellen's reputational risk has fallen significantly. Her incentive to keep rates lower for longer is diminished.
And maybe – just maybe – Yellen is thinking that allowing a bit of panic in the stockmarket, some jitters in the Treasury market, a bit of a slowdown in the economy – maybe that would wipe the smile off Trump's face. If nothing else, it'd force him to step up with all this fiscal help he's promising.
"You reckon you can clean up this mess, pal? Be my guest."
This is what happens when central banks and governments fall out. This is what happens when power transitions take place. Markets have got comfortable with one governance regime, but it's changing fast.
Expect things to get broken along the way.