There is an old adage about the primary role of a central bank being to play the party-pooper.  William McChesney Martin, the Chairman of the Federal Reserve from 1951 to 1970, famously said that the job of a good central banker was to take away the punchbowl just as the party gets going.  i.e. Raise interest rates in order to lean against a strengthening economy so as to prevent an inflationary boom from taking hold. 

However given the amount of damage the recent recession has caused to the economy (with capacity utilisation printing a low of 68.3% in June 2009 and the unemployment rate topping out at 10.1%) then the Fed is going to allow this current recovery to fully take hold and develop some real momentum before it dares to take back any of its rate cuts.  There is currently still too much spare capacity to be chewed through before any dangers are presented by a pickup in inflation.  Capacity utilisation rates of approx 80% (the average since 1972) and unemployment below 6% are the hallmarks of an economy functioning somewhere between not-too-cold and not-too-hot.  The latest data showed unemployment at 9.7% (which may well rise as a strengthening jobs market tempts people to restart job hunting) and capacity utilisation of 72.7% which clearly shows the economy is moving in the right direction but still has a long way to travel to approach anything resembling normality.

For their part, the BoE have made clear that they do not expect the level of GDP to return to its pre-recession trend until at least 2012, as this recovery slowly absorbs the spare capacity in the economy.  Hence they will be in no hurry to raise interest rates either.

The two central banks could always first drain off some of the money they have injected into their economies (thus far £200 bln and $1.73 trn via QE bond purchases).  In the long term the central banks will get their money back as these bonds mature but they could choose to sell some of their holdings into the Gilts/Treasury markets.  As they have now stopped buying bonds for their QE programs, presumably the current market prices for Gilts and Treasuries exist without central bank intervention.  However bond markets would surely react very badly to proposed central bank sales.

This week’s FOMC statement showed that Hoenig remains the lone hawk and has not yet convinced any other FOMC members to deviate from their wish to keep interest rates ”exceptionally low…for an extended period”.  The problem with Hoenig’s view is that the Fed currently has the pedal pressed all the way to the metal and employers are still not hiring extra employees.  Hoenig’s view may gain more traction after a few months of sharp job gains (e.g. +300k/+400k) but until then he is likely to remain the lone hawk.

Until we see many months of sharp job gains combined with the unemployment rate dropping, we can expect the Fed to keep topping up the punchbowl in order to keep this party going for some time yet.  Eventually the Fed will wish to slowly take back some of the rate cuts which got us down to 0.25% in the first place.

The Fed and the BoE are going to allow themselves to fall behind the curve as they seek to hold rates low whilst an economic recovery gains traction and begins to absorb some of the spare capacity which has been created by the recent recession (i.e. unemployment falls and manufacturers’ capacity utilisation rises).

We saw the first inklings of how this will play out in practise after last Friday’s US employment report.  A stronger than expected 4th December 2009 report (which showed the unemployment rate falling by 2/10ths and non-farm payrolls essentially unchanged at -11,000, together with the prior two months revised to show 159,000 fewer jobs lost) caused the market to price in a rate hike by the Fed in Q2 2010 and the Dollar rallied on expectations of US rates rising.  However the Fed will probably keep rates on hold for far longer than the market currently thinks and we are going to see repeated attempts by the market to price in a series of rates hikes which will fail to materialise on time as the Fed stays firmly & willingly behind the curve.

So the US and UK yield curves are likely to steepen further as the Fed and BoE deliberately keep rates on hold whilst an economic recovery builds strength and they will want to see their respective unemployment rates much, much lower before they dare to begin hiking rates.  The press may ascribe 10-year Gilts selling off (higher yields) to worries about Labour’s complete unwillingness to sketch out a plan to bring the budget deficit back under control but actually the gilts market doesn’t care about Labour’s economic plans because the view at the moment is that the Conservatives are going to win next May’s general election and it will be their budget plans for 2010-15 which will matter. 

The more likely explanation for higher 10-year yields is that government bonds always sell off when the market scents economic recovery and last Friday’s US employment report hinted towards a sustainable trend of lower unemployment and consequently stronger GDP ahead. This is also why the strong correlation between a weaker Dollar & stronger stockmarkets (which has been maintained since stockmarkets bottomed in March 2009 all the way up until last Friday) now appears to have broken down. Markets are now sensing growing GDP which implies corporates will grow their top line sales (hence higher profits, so the stockmarket rally continues) and growing GDP also implies US Dollar strength after the weakness we have seen in the last 9 months. 

So two central banks have led the way and raised interest rates (Australia and Norway), starting their journey on the long way back to interest-rate normality.  But it does not necessarily follow that just because two commodity-linked countries have started to hike rates, the Fed, BoE and the ECB are about to follow suit anytime soon. Speculation that the Fed and BoE are contemplating rate hikes is way too premature – the order of events will surely be for Quantitative Easing spending to be halted first and only then will the central bankers turn to taking back some of the rate cuts they have implemented since the summer of 2007.

The US has recently reported GDP turning positive in the third quarter of this year but the US economy is still far too weak for the Fed to risk halting QE anytime soon, let alone even think about raising interest rates from their current floor of 0.25%. One positive quarter of GDP is just the start of a potential recovery  (which could easily fizzle out again next year) and the Fed made it clear in their Fomc statement earlier this week that rates are staying put “for an extended period” and the Fed won’t even finish spending its current $1.75 trillion QE money until the end of March 2010. As was announced today, US unemployment is still rising and has now reached 10.2%.

Similarly the Bank of England this week increased by £25 bln its QE target to £200 bln, to be fully spent by the end of January 2010.  The BoE will most likely decide to print even more money if GDP does not return to growth in Q4 (after the surprise of the UK posting another quarter of recession in Q3).  As the BoE will not raise rates ahead of next year’s General Election, theoretically the ECB is in line to be the first of the major Western central banks to implement a rate hike as they never embarked upon QE in the first place.  However the jury is out on whether the ECB will raise rates with Spanish unemployment of almost 20% and with Ireland looking set to go to the IMF to seek a loan.

Inflationary pressures will not be seen in the UK until a lot more of the £200 bln QE money finds its way off deposit at the BoE (where £151 bln currently sits) and out into the wider economy where it can begin to chase the price of goods & services higher.  Therefore the BoE will only come under pressure to raise rates in the near term if the Pound Sterling collapses.

So the sight of central banks raising rates looks to be spotted for the time being only in the economies of the world which export commodities.  China will probably be the first Asian central bank to increase rates because the Yuan is closely tied to the US Dollar and other Asian countries do not want to raise rates and cause their currencies to appreciate against the Dollar or the Yuan.