Ideally, a rise in the price of oil, resulting from improvement in worldwide economic conditions, would increase inflation expectations and also pull up long-term interest rates. This could steepen the yield curve, or at least displace it upwards. All other things being equal, bank shares would benefit and their poor performance of the last few weeks would turn around. Even though higher interest rates would penalize a certain number of sensitive sectors, the breath of fresh air for the banking sector would restore some appetite for risk which has recently been lacking.
More realistically, i.e. with an economy well into the expansion phase, there is little chance this series of events would last. It is not even sure they would have the time to develop in the first place, despite some indications to the contrary over the past few days.
Following the last monetary policy meeting on 25 January, there had been an increasing number of statements suggesting growing discomfort with the status quo advocated by Mario Draghi and his chief economist Peter Praet. Looking at the various comments, and particularly the optimistic tone of Benoît Cœuré, it seemed that the ECB would soon adjust its policy to provide less support to the economy. Since its asset purchase programme was scheduled to last until late September, many expected that, this spring, the ECB would state its intention to end the programme, and some even thought that it would mention a possible timetable for raising official interest rates in 2019. It therefore seemed that rates would rise, the yield curve would steepen, banks would enjoy better conditions and the euro would continue rising. However, the resulting euphoria did not last long. With a few days to go until the 8 March monetary policy meeting, the prospect of the ECB changing direction seems increasingly remote.
“The first increases in short-term rates might not occur until the unemployment rate is considerably below 6.5 percent”! Ben Bernanke, Sept. 18, 2013
The Fed has dared to act contrary to expectations—and rightly so. This was no easy move, given that since early summer the markets have talked themselves into believing that central bank policy was about to change. Yet the reasoning behind the FOMC decision couldn’t be clearer:
The U.S. economy is still on extremely shaky ground. Growth has yet to pick up; job gains remain mediocre; disposable income is still too low to drive a lasting recovery in consumer spending; and businesses are not investing.
Yields have risen so sharply since the start of the summer that they have come to pose a threat to growth, as demonstrated by the sudden halt to the housing market uptick since the spring.
The lower jobless rate doesn’t reflect improvement in labor market conditions. If anything, it shows that they have continued to get worse. The labor force participation rate is in free-fall—in other words, more and more working-age people are simply dropping out in discouragement.
Fiscal policy is highly restrictive and will remain so—just when implementation of health-care reform prior to year-end is likely to take a large bite out of personal income.