HAMISH MCRAE: US leading world back to common sense

If you wanted a reminder of where power lies in global finance, this weekend is as good as any. It is in America. This is not simply because the US is the world’s largest economy, or that US stock markets account for more than half of the global total. 

It is also because the rest of the world looks to US leadership in financial affairs. In particular, what the US Federal Reserve does shapes the policies of all the other central banks in the world. And that is why global markets are paying huge attention to what Jay Powell, chair of the US Fed, said at the annual gathering of central bankers at the resort town of Jackson Hole in Wyoming on Friday.

In a normal year the Jackson Hole meeting is a sedate, academic affair. Since 1982, central bankers, economists, academics, US officials and so on have been meeting there to talk about long-term forces shaping the world economy and its money markets. This year things are not sedate at all. Everyone is scared, and we all know why. The core task of central banking is to maintain financial stability. Back in the early 1980s, the great threat was double-digit inflation, a beast that was beaten by the harsh policy of double-digit interest rates. 

Even a year ago they weren’t really worried. The Fed thought that the slight rise of inflation was ‘transitory’. There was no need to increase interest rates and the cash fed into the markets by quantitative easing would be ‘tapered’ down slowly. The markets were reassured, and the stock market boom continued in America, pulling up share prices everywhere, until the end of the year. 

The Fed now knows its complacency of a year ago was absurdly misguided. All the progress of 40 years of fighting inflation is at risk. But just as the markets took comfort a year ago from the calm-down message – before they realised they had been misled as the Fed started upping interest rates faster than they expected – so they are again looking this weekend for guidance. So what is the message now? 

Well, Jay Powell talked tough. I think he had to. Getting back to the Fed’s 2 per cent inflation target was its ‘overarching focus right now’. ‘Restoring price stability will likely require maintaining a restrictive policy stance for some time,’ he said. ‘The historical record cautions strongly against prematurely loosening policy.’ 

But what does this actually mean, not simply for the US but for the rest of us too? If the Fed’s target interest rate peaks at somewhere between 3.5 per cent and 4 per cent, does that mean the Bank of England base rate will go there too? 

Will ‘a restrictive policy for some time’ mean that there will be another downward leg to US share prices, after the partial recovery since mid-June? And will UK shares, which are cheaper than US ones relative to company earnings, be able to resist a downturn in US markets if that does happen? 

It is always worth waiting a few days for things to settle down after a major policy speech such as this, because first reactions are often wrong. We have this Bank Holiday weekend to reflect, and the US end-of-summer holiday, Labor Day, is another week away. But for what it is worth here are my five main takeaways. First, Jay Powell means what he says. The Fed will lean against inflation until it comes down towards the 2 per cent target in a sustainable way. 

Two, that means the Bank of England will have to do the same. Our own prospects are confused by the new Government and the big increase in borrowing needed to offset the surge in energy costs. But it will be tough to maintain confidence in sterling through the autumn and we absolutely don’t want a run on the pound. So the pressure will be on the Bank to keep punching up rates until there is a turning point for inflation. 

Three, while I don’t know where that peak for rates will be, I’m still not sure that a recession is inevitable. The winter will be confused but the great wodge of Government funding to offset energy bills should stop the economy contracting by much, maybe not at all. 

However, number four, the climb in UK house prices will be capped by rising mortgages. Probably not a crash, just a more muted market. And finally, what about equity prices? The immediate reaction was for US shares to head sharply downwards, though there was less of a move in London. Let’s wait a few days. 

My instinct is we are back to markets where value matters. Solid companies with decent earnings will do fine, but froth will be blown away. If that is right it will be good news. The US is leading the world back to common sense. About time, but welcome all the same.