EUR 268.86 For Business Accounts Only

FOMC Unlikely to Change Policy Course As Members Seek To Reduce Tolerance for Low Risk Premiums

Some commentators believe the tone of the minutes to the 2-3 May Federal Open Market Committee (FOMC) meeting strikes a more cautious note about policy normalisation. Despite continued low inflation, members believe, however, that Q1 non-farm payroll growth, if sustained, would produce further labour market tightening, thereby justify the removal of policy accommodation.

Although the Phillips Curve remains integral to the Fed’s econometric model of the US economy, the stability of the inverse relationship between unemployment and wage inflation has been increasingly questioned. During the previous two occasions (1997 & 2006) when unemployment dropped to low levels, inflation eventually reared its head to force a policy response from the Fed that has ultimately resulted in recession.

Absolute measures of US equity valuation are not indicating bargain-basement opportunities, but their valuation against bonds remains bullish, even according to the Fed’s own model of equity valuation.

Former Fed Chairman Greenspan’s reference to irrational exuberance was about how persistently low inflation could drive risk premiums to unrealistically low levels, thereby potentially creating a source of economic instability. These dynamics happened in Japan and the US, particularly in the latter’s case after the bursting of the technology and housing bubbles.

The Fed deliberately aimed to reduce the equity risk premium via its quantitative easing programmes, but these measures also lowered the default premium demanded in the corporate bond market. Irrational exuberance in the 21^st Century has largely manifested itself in a quest for yield versus sustained misallocation of capital to fund capacity growth in any particular sector of the economy, such as housing or technology.