Yesterday's post suggested that UK rates will rise soon. It would be unusual for the MPC to tighten policy when the Federal Reserve is still loosening, via its QE2 securities purchases. Will the Fed's stance also shift over coming months?
The first chart shows US official interest rates together with a leading indicator of Fed policy based on trends in unemployment and core inflation and a measure of supply bottlenecks from the ISM manufacturing survey. The indicator is constructed so that a positive reading signals a need for tighter policy and vice versa. (The Fed has stated a target for the Fed funds rate since 1995; the discount rate is used as the official measure for earlier years.)
The indicator turned negative in June 2007, three months before the first Fed rate cut and six months before the onset of the recession. It continued to weaken during 2008 and early 2009, reaching a trough in May before embarking on a sustained recovery. Since mid 2010 the indicator has been hovering just below zero.
Of the components, the ISM bottlenecks measure is already positive. Labour market leading indicators, meanwhile, suggest that the unemployment component will move above zero during the first half of 2011. Core inflation, therefore, may need to fall further to keep the indicator in negative territory. Core CPI trends, however, may deteriorate, with goods inflation boosted by pass-through of cost increases and the important housing rents component firming in response to a falling rental vacancy rate.
So the Fed leading indicator could turn positive as early as this spring, suggesting an increase in official rates in the late summer.
The second chart shows how the Fed is progressing with its plan, announced in November, to buy a net $600 billion of securities by mid-2011. While the purchase programme is on track, the impact on bank reserves and the monetary base has been smaller than expected, implying partial sterilisation. This could indicate that the Fed is already concerned about overstimulating the economy; there is an outside chance that it will end QE2 early in the event of strong data over the next couple of months.
