Last week there were two meetings that will shape global financial and economic matters in the months to come. These were the June meetings of the Federal Reserve of the United States and of the European Central Bank.
Last week, on Wednesday, the Federal Reserve raised interest rates and indicated that two additional increases were on the way this year. This was a clear sign that the Board of the Federal Reserve is confident that the US economy was strong enough for borrowing costs to rise without hindering economic growth.
Wednesday’s rate increase was the second in 2018 and the seventh one since the end of the recession triggered by the 2008 international financial crisis. This has brought the benchmark rate of the Federal Reserve to a range of 1.75 to two per cent. The last time the rate was at two per cent was a decade ago and at that time, the trend of interest rates was a downward one not an upward one.
Jerome H. Powell, the Federal Reserve chairman, speaking to the media, said that the US economy had strengthened significantly since 2008 and was approaching a situation that could allow the Federal Reserve to soon step back and play a less active role in encouraging economic activity. This monetary policy stance about the state of the US economy is likely to mean higher borrowing costs for households over the next year.
However it is also the result of a buoyant labour market. On the other hand, in spite of low unemployment (3.8 per cent at the last count), wages continue to grow very slowly.
As such, there is the risk that wages would not increase by as much as the increase in borrowing costs.
The Federal Reserve must therefore perform a very tight balancing act. If it maintains a high pace of rate increases while wage increases remain muted, there is the risk of an economic slowdown as purchasing power diminishes.
If it slows the pace of interest rate increases, inflation could spiral out of control and this could result in an economic slowdown.
The Federal Reserve needs to keep a watchful eye on the economic situation to make sure it keeps chugging along
This catch-22 situation means that the Federal Reserve needs to keep a watchful eye on the economic situation to make sure it keeps chugging along. However the predictions for the US economy are very positive.
As I mentioned in the first paragraph, last week there was also the meeting of the European Central Bank. At the meeting it voted to stop its quantitative easing programme of buying bonds in December of this year. Since the start of this programme, the ECB has bought over two trillion euros worth of government bonds. Despite warnings by analysts that the euro zone area was going through a soft patch at a time when the risk of trade protectionism is rising, the ECB said it would wind down its bond purchases over the next six months.
It is estimated that the quantitative easing programme contributed 0.75 percentage points a year to the average 2.25 per cent annual growth rate.
However interest rates in the eurozone are likely to remain at their current record low levels until mid-next year. This reflects an element of pessimism on the part of the ECB. In fact, it has cut the growth forecast of the eurozone, blaming this decision on the trade wars.
As such, while the meeting of the US Federal Reserve denoted a very bullish attitude towards the US economy, the meeting of the ECB highlighted a level of uncertainty. Admittedly the eurozone is slightly behind the US in its economic cycle and this may explain the divergent views.
The reaction of the financial markets has been a weakening of the euro against the dollar. The euro has also continued to weaken this week.
However, stock markets in Europe surged forward as exporting firms are expected to do better and investors are seeking to place their money in instruments other than savings.
To a certain extent, Europe is at an advantage when compared to the US. The US economy shall be exiting the strategy of low interest rates first. The consumer reaction to this, as banks raise lending rates, is still uncharted territory, and the US experience could provide some pointers as to how the ECB can approach this matter.
Being a member of the eurozone, Malta’s fortunes are tied to those of the single currency area. The weakening of the euro will be good news to exporters, tourism operators and service providers. But as a country we need to be prepared for a regime of higher interest rates and we need to assess whether our current patterns of consumption can be sustained as interest rates rise in 2019.