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The Fed maps a path in unknown territory

 Photo: Shutterstock

Photo: Shutterstock Photo: Shutterstock

The US Federal Reserve’s latest statement on monetary policy shows just how deep into unknown territory the global financial system has come.

The Federal Open Markets Committee, which sets targets for interbank lending, has left rates on hold in the range of zero to 0.25 per cent – the ultra-accommodative stance it has held for six years.

But although the Fed has not seen the US economy, or global economic forces more widely, hitting the required benchmarks for monetary tightening, futures markets are still pricing in a hike in the months ahead.

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That’s the ‘unknown territory’ effect. The Fed has just never done this before.

In normal times, the Fed focuses on two economic indicators when setting rates – its job is to “foster maximum employment and price stability”.

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The Fed has gone where it’s never ventured before. Photo: Shutterstock

At present it has neither of these things. Following its six-weekly meeting on Wednesday, the FOMC said in a statement: “The pace of job gains slowed and the unemployment rate held steady.

“Nonetheless, labour market indicators, on balance, show that underutilisation of labour resources has diminished since early this year. Inflation has continued to run below the Committee’s longer-run objective, partly reflecting declines in energy prices and in prices of non-energy imports.”

So the jobs situation (cross-fingers) looks hopeful, and inflation is too weak but (cross-fingers) might come back into the target band if oil prices recover and the super-strong greenback weakens a bit.

That’s a lot of a finger crossing, and that leads many economists to think rates will never be raised — they are assessing the indicators from a pre-GFC perspective.

In the post-GFC world, however, there is growing doubt that keeping rates super-low for a long time does any good at all.

In the past year, while ‘base money supply’ has increased (that is, banks have borrowed from the Fed) the finance industry has failed to turn a large part of that increase into new loans.

That means that bank reserve account are full of dollars, but the normal process of ‘creating’ new ‘broad money supply’, which happens when banks write loans, is stalling. So, broad money supply is no longer responding to the Fed’s super-accommodative position.

Moreover, some economists now think the Fed’s position is part of the problem.

In the past week, investment bank JP Morgan argued that the Fed’s low rates are actually damaging confidence.

If they’re right, that means inflation will never get back to the 2 to 3 per cent target band on current settings, and jobs growth will continue to languish.

This position seems to be gaining traction with traders.

When the FOMC report came out overnight, futures market pricing for a rate hike shifted substantially – largely because the FOMC dropped references to fears that emerging markets were in danger of going backwards.

The probability of a hike at the next FOMC meeting in December went from 35 to 44 per cent, and the probably of a hike by January went from 43 to 52 per cent.

That is, the Fed looks increasingly likely to close its eyes and pull the rates trigger, thereby ending an extraordinary period of financial history – for better, or worse.

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