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Chief economist update: The Fed and Australia

Just when we thought Federal Reserve chair Jerome Powell has tapered sooner-than-later taper expectations, along comes Robert Steven Kaplan -- president and chief executive of the Federal Reserve Bank of Dallas.

While the US Federal Reserve was waxing optimistic on the outlook for the general economy at the conclusion of its 27-28 monetary policy deliberations, it cautioned that, "The path of the economy will depend significantly on the course of the virus, including progress on vaccinations" and while measured inflation has risen, it's largely temporary and that "The ongoing public health crisis continues to weigh on the economy, and risks to the economic outlook remain."

But Bob Kaplan begged to disagree (and he knows what he's talking about).

In a virtual conference with the Montgomery Area Chamber of Commerce, Kaplan cautioned that "we are now at a point where I'm observing excesses and imbalances in financial markets" -- "historically" elevated stock prices, tight credit spreads, and surging house prices.

And therefore, "I do think, at the earliest opportunity, I think it would be appropriate for us to start talking about adjusting those purchases [the Fed's US$120 billion monthly purchases of US Treasuries and agency mortgage-backed securities] while at the same time repeating his expectation that the US central bank will have to start raising interest rates as soon as next year.

The strengthening momentum in the US economy backs up Kaplan's rationale.

The thing is, if the US starts tapering and liftin interest rates, it will have a flow-on effect on Australia - good and bad and ugly.

The good. Higher US interest rates would lift the US-Australia interest rate differential and by extension, lower the A$/US$ exchange rate.

Onya Australia! The cheaper A$ lifts the competitiveness of "Made in Australia" products and services and at the same time, raises the profits of local companies earning US dollars when "translated" back into Australian currency.

Not to mention, the rise in the share prices of Australian firms when they convert their US dollar earnings back into local currency.

The bad. Australia would be forced to compete for the higher interest rates offered in the United States. As we've witnessed over the past few months, Australian bond yields (and those of other major economies) have risen in line with the ascent with their US counterparts. This bad news for both existing US and Australian bond holders as the price of bonds fall.

The ugly. While recent activity indicators have been improving, risk remains until the coronavirus pandemic is completely vapourised. A sooner-than-expected removal of policy accommodation and lifting of interest rates could jeopardise or worse, reverse, the gains that the global economy has achieved over the past pandemic year.

Then again, the question must be asked: Have government and central bank stimulus measures gone over and beyond that they're now smothering the successes achieved during this pandemic?

Kaplan is correct to be concerned. Extended monetary and fiscal stimulation is leading to "excesses and imbalances in financial markets" if not already.

Still, it's better to be safe than sorry. Besides, given all things relatively (and in consideration of the still on-going pandemic) bright and wonderful taking place in the Australia to date, the domestic economy could withstand if ever and whenever the Fed decides to taper policy accommodation.

Read our full COVID-19 news coverage and analysis here.