Predicting the future purely as a matter of interest

Wayne Arnold

• Last Updated: November 04. 2009 6:53PM UAE / November 4. 2009 2:53PM GMT

By the time you read this column, it will have successfully predicted the future. No, not whether the New York Yankees will defeat the Philadelphia Phillies this week to win baseball’s World Series (they will). It is going to foretell something almost as important: that the US Federal Reserve will have elected not to raise its benchmark interest rates at its regular rate-setting meeting on Wednesday in Washington. The Fed’s Federal Open Market Committee (FOMC) announced its decision several hours after this column went to press in Abu Dhabi, so if you are reading this and the Fed has raised rates, then I would like to say right now just how surprised I am and apologise. Sorry.

This is, however, not what you might call a bold prediction. A bunch of very smart people with lots of money riding on the outcome are also fairly confident that the Fed’s federal funds rate, its target for what banks charge each other for loans, will remain between zero and 0.25 per cent.

Obviously I cannot read Ben Bernanke’s mind from such a distance and I have not yet managed to plant microphones inside the Marriner S Eccles Building where the FOMC meeting is held. Instead, I spoke with Ilan Mihov, an economics professor at INSEAD, the French business school, who earned his PhD under Mr Bernanke, the Fed Reserve chairman, at Princeton and authored several papers with him.

Big deal, you may be saying. Why should you care about the Fed funds rate? Well, the Federal Reserve sets monetary policy for the world’s biggest economy and in doing so sets the price for borrowing the world’s most popular currency, the US dollar. Because most commodities are priced in US dollars and some currencies – such as the dirham – are fixed at a specific rate to the dollar, US rates pretty much determine the cost of borrowing everywhere else. The Fed has set its rates at record lows in an effort to halve the financial crisis and kick-start the US economy, and pledged to keep it there for an “extended period”. It seems to have worked. The US economy grew 3.5 per cent in the third quarter, ending the worst recession anyone can remember.

This “zero interest rate policy” has also sparked a worldwide rally in financial markets, as investors borrow dollars at super low rates and then invest them around the world in search of higher returns. Money men refer to this as a “dollar carry trade”, and it is in part why investors are now willing to lend to heavily indebted borrowers such as Dubai, whereas six months ago they would have been reluctant.

And because low interest rates lower the cost of funding for companies, they tend to buttress optimism about corporate profits, helping to send stock prices up, too. But low interest rates can also fuel inflation and economists warn that inflationary expectations are also partly behind the worldwide rally. With more and more dollars floating around, many investors are eager to buy hard assets, whether commodities such as oil, property and stocks or currencies that are not fixed to the dollar.

With many hopeful that developing nations, particularly in Asia, Latin America and the Gulf, will see faster growth than others as the global economy recovers, their markets are booming. Perhaps too much, though. The IMF and the World Bank are joining private sector economists in warning that emerging markets may be experiencing a new bubble. Some governments, notably China, Hong Kong and Singapore, are now working to cool rapidly rising property prices.

Global asset prices, therefore, hinge on the Fed’s rates decision in a perverse way: if the Fed says the US economy is too weak to raise rates, it could paradoxically fuel the global rally even though exporting companies and the nations that rely on them will be hurt by continued US weakness. And if the Fed says the US economy has strengthened to the point that inflation is now a risk, it could be bad for global markets because it would mean the cost of borrowing dollars would head upwards, reducing investor appetite to chase higher yields in riskier markets elsewhere.

With signs increasing of a US recovery, some economists say the Fed ought not to extend its zero interest rate policy or the US, too, could see a dangerous revival of inflation, setting the stage for another market crash and perhaps a new crisis. Others believe the Fed does not have the guts to raise interest rates and head off inflation so long as recovery is still so uncertain. While the economy is growing again and manufacturing appears to be recovering, the US consumer still appears weak. Nearly one in 10 Americans are unemployed, and while some economists predict that jobs will bounce back, for now consumers are sitting on their hands.

Personal incomes are still falling. So is spending, in particular something called the personal consumption expenditures index, which Mr Bernanke is said to be particularly enamoured of when gauging the likelihood of inflation. Mr Mihov disagrees with those who say Mr Bernanke is weak on inflation and is instead allowing the US to inflate its way out of recession.

That is an accusation particularly vexing to countries such as China and the UAE, which lend lots of dollars to the US. Inflation lowers the real value of their repayments, particularly if it is accompanied by a declining dollar, as is now the case. Mr Mihov thinks that Mr Bernanke has inflation-busting in his DNA. Like many central bankers he understands that giving in to the temptation to reflate the economy can mortgage the nation’s future by raising its future cost of borrowing.

But Mr Mihov also disagrees that the Fed’s easy money policies are creating inflationary risks. Those that believe so point to a decline in manufacturing capacity during the crisis, saying it may have reduced or even eliminated the gap between US economic output and its potential output. When that happens, prices start climbing.

While the output gap may be hard to determine, unemployment is not, and unemployment is a generally accepted indicator of the output gap. With unemployment running near 10 per cent, Mr Mihov argues, the output gap is in no danger of closing. Inflation remains a distant threat, therefore, and the economy remains in need of low interest rates to nurse the recovery. Global markets may therefore be able to count on the Fed to keep the dollar carry trade rolling along. But what markets will do, no one can say.

warnold@thenational.ae