William De Vijlder draws a picture of today's economic landscape and analyses the possible implications for the long run.
Of course, the exchange rate is a relative price of two currencies, so the Federal Reserve stance will also be a driver, not to say the most important one. Indeed, the second semester shapes up better on the growth front than the disappointing first half of the year and the pace of job creations has been well above what it needed to stabilise the unemployment rate, which is already very low. Unsurprisingly, the tone has become more hawkish and the debate amongst economists has shifted from the possibility of a new hike to the timing of such a move: September or December? Yet, the fixed income markets are not fully pricing in a move between now and year-end. It is tempting to label this as complacency, but it can also reflect international influences. Global spillovers of domestic monetary policy are a well-known phenomenon and since the global financial crisis, there have been many analyses showing the impact of Federal Reserve policy on the interest rates and exchange rates of other countries. What seems to be rather new is that it also goes in the other direction. When bond yields are negative in an increasing number of countries and for ever longer maturities, US yields end up looking pretty attractive even though in the absolute they are also low. In a way this weighs on the influence of the Fed on the long end of the yield curve. Another factor which contributes to keeping US bond yields low is the Fed's credibility: investors are convinced that it will not rock the boat and hence will be very cautious in hiking rates. The growing emphasis of Fed officials on the neutral rate of interest being very low goes in the same direction. The neutral rate is the rate which neither stimulates nor slows down the economy. A low neutral rate implies that the cumulative tightening in this cycle should be limited and hence should not cause any disruption to speak of in the real economy. This would imply that the prospect of a Fed tightening later this year becomes less of an issue.