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The FED's Policy in Today's U.S. economy

Even if the US monetary policy led since 2008 has made it possible to restore economic growth, it has fostered bubbles on financial assets. The increase in the value of the NASDAQ confirms the levels reached by US equity markets.
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Janet Yellen, chair of the U.S. Federal Reserve, speaks during her semiannual report on the economy to the Senate Banking Committee in Washington, D.C., U.S., on Thursday, July 16, 2015. Yellen said the Federal Reserve is 'highly focused' on the risks of raising interest rates too early. Photographer: Drew Angerer/Bloomberg via Getty Images
Janet Yellen, chair of the U.S. Federal Reserve, speaks during her semiannual report on the economy to the Senate Banking Committee in Washington, D.C., U.S., on Thursday, July 16, 2015. Yellen said the Federal Reserve is 'highly focused' on the risks of raising interest rates too early. Photographer: Drew Angerer/Bloomberg via Getty Images

The US economy is the strongest it has ever been, it has not been more healthy and buoyant since the financial crisis of 2008. All the indicators of the US economy are in the green. Indeed, monthly employment figures confirm this vitality. This buoyancy has been epitomized by significant and constant job creation for several years. We need to go back to 2008 to find an unemployment rate equivalent to today's 5.1%.

Job creation in the US is currently strong and appears to be sustainable. This stability is reassuring for economic factors. Job growth is a signal of a strong US economy. The weaker the unemployment rates, the more Americans are confident in the future. This confidence has translated into an immediate increase in consumption.

US growth essentially rests on household consumption. The more households consume, the more firms benefit. Pension fund savers and their pensioners are thus reassured. Domestic consumption weighs heavily on the US economy since it accounts for more than 70% of GDP.

Households have continued to benefit from the drop in oil prices. The fall in this cost item has enabled US households to increase their purchasing power. At the same time, the real estate market has been particularly buoyant in the same period. The buoyancy of the real estate market encourages households to consume since they are confident in the future of the country.

Another economic indicator is inflation. The latter should not exceed 2% this year. Wage inflation has remained low. On the contrary wages have stagnated since 2008. US ten year rates should be in the neighbourhood of 2.5% at the end of 2015, that is to say an increase of 60 basis points compared to their current level. Most firms will not be affected by this rise since they are financed by short term rates. Long term rates mainly finance medium and long-term investments like real estate.

The FED's rate policy

The FED will increase rates in the near future. In the current environment, this gamble is not at all risky. Since 2008, the base rate has been maintained at 0.25%. Such a low rate had never been recorded over such a long period of time. Since 2008, the major central banks have injected more than hundreds of billions of dollars into financial markets. Investors currently have to pay to lend their liquidities to governments.

This surrealistic situation has lasted for a few years. These near-zero interest rates responded to an emergency situation at the time of the 2008 financial crisis. The new rates will continue to stimulate growth while reflecting the current economic situation. The FED's message today is to tighten monetary conditions.

The objective of the US Federal Reserve remains price stability, maintaining full employment and keeping long-term interest rates moderate. With the increase of the money supply in the last 15 years, the FED's balance sheet accounts for 20% of GDP whereas the ECB is approaching 30% of the GDP of the Euro zone.

The FED had used lowering interest rates as early as 2001 under Alan Greenspan. The benefits of this policy were neutralized by a succession of austerity policies whose objective was to control the public debt. Zero rates were supposed to encourage investors to take more risks to jump start the economy. Alan Greenspan also wanted to reinvigorate the residential real estate market at the beginning of the year 2000. The increase in real estate prices was also going to help Americans refinance their equity and to obtain immediate liquidities. This alternative enabled households to use the tradeoff between them to consume.

Nevertheless, it has had to make do with the fall in commodity prices such as the price of the barrel of oil which stood at $46 on September 2 and has dropped continuously in the last few weeks. The oil price fell to an all time low at $38 on August 24, a level never reached since March 2009.

The Chinese financial crisis which started in June 2015 should also be taken into account by the FED, as well as consequences of the third Greek bail-out package for its creditors. The Chinese currency fell to its lowest level in four years to reach 6.3563 Yuan Renminbi for a Dollar on September 2. US exports to China only account for 1% of its GDP. Nevertheless, a long Chinese slowdown could negatively impact emerging economies and world growth.

The consequences on the US economy

The rise in interest rates will also depend on the statistic results in the coming weeks. After the first increase in the FED rates, the latter will pay close attention to the reactions of the factual economy, the equity and bond markets. It will also follow the behaviour of investors with regard to the quantitative easing of other central banks. The increase in FED rates will affect the cost of credits to firms and households which will have to take on long term debt. The house-building industry sector is particularly sensitive to interest rate levels. The higher the interest rates, the more immediate the impact on the building of new housing will be.

If rates were to be increased too significantly, it would impact the cost of money in The United States as well as US consumption. By keeping rates low, central banks have not encouraged governments to reduce their public deficits. It has reduced the US bonds cost but not the deficit level.

Low rates have financed financial markets, but not directly the factual economy. The economy needs to go back to savings based on profitability rather than capital gains. Today's low returns on investment increase the disconnection between prices and value. Value is no longer a true representation of the factual economy, nor its fundamentals. The risk of a correction in stock market valuation due to an increase in interest rates is very real. When, for example, the price of real estate assets have been supported by very low interest rates and by abundant liquidity levels for several years, exiting an expansionary policy is not without consequences since it impacts asset prices. When there is a drop in the wealth effect, both the consumption of consumers and investors naturally fall too. In such a pattern, growth will follow a similar curve.

On balance, even if the US monetary policy led since 2008 has made it possible to restore economic growth, it has fostered bubbles on financial assets. The increase in the value of the NASDAQ confirms the levels reached by US equity markets. Since China stock market has fallen sharply, the US stock market has also suffered. The volatility of US stock market over the last few weeks contrasts with the domestic economic growth over the last four years.

With 173,000 new jobs created in August, the slowdown in job growth and the absence of any wage pressure, the FED will likely delay the interest rate rise in the next few weeks. This will create downward pressure on the stock market even as investors are bracing for interest rate increases.