Rpt-MNI INTERVIEW: Fed Probably Needs Bit More Tightening-Aikman

The Federal Reserve will probably need to raise interest rates a bit further over the next six months in order to ensure wage growth cools in a way that’s consistent with returning inflation to its 2% target, David Aikman, a former Bank of England staffer who also spent two years at the Fed’s board of governors, told MNI.

Aikman said the risks of doing too much still outweigh the risks of doing too little, because rate hikes could be reversed rapidly if needed.

“I don’t think we’re in for another 100 basis points, but it wouldn’t surprise me if they felt they needed to do a little bit more,” he said in an interview.

“You could always cut rates aggressively if it turns out the economy’s slowing sharply. We know from history that medicine works quite quickly, whereas I don’t think they’ll want inflation hanging around above target.”

U.S. inflation has come down quickly from peaks above 9% last summer to a 2-½ year low of just above 3%. However, core inflation, which excludes food and energy prices and is seen as a better measure of underlying price pressures, is still hovering above 4%, more than twice the Fed’s goal.

“Wage growth is still significantly above where I think it would need to be for medium-term price stability. It does feel like there needs to be a little bit more cooling,” said Aikman, who spent 17 years at the BOE and is now director of the Qatar Center for Global Banking and Finance at King's College.

“Whether that happens immediately or not in terms of rate hikes or they do a little bit of a pause to get a slightly clearer sense of what direction things are heading. Over the next six months I’d expect them to tighten.” (See MNI INTERVIEW: Fed Will Hold For Long, Could Hike More-Hoenig)

For now, markets expect the Fed will hold rates steady at its September meeting, though the decision ultimately hinges on looming inflation and employment reports.

DAMNING INDICTMENT

Aikman, an expert on financial stability, said risks on that front have receded because of central banks' interventions but certainly not vanished, particularly when it comes to market liquidity.

“We had quite a bit of breaking happen on both sides of the Atlantic in terms of the financial system. Ultimately, there was a bailout of sorts that stopped that from turning into something much more serious,” he said.

“Generally, there seems to be a lot of complacency about the ability of central banks to come in and just solve those issues. I’m less confident that that’s something that should be relied on.”

Aikman said the recent spike in 10-year Treasury yields is likely to exacerbate the problems faced by U.S. regional banks in March, an episode of turmoil that generated an aggressive Fed response, including the creation of a new special lending facility.

“I can’t see that problem has been solved, so for those smaller banks, that is going to be a hit to their capital position and we’ll see further tightening in credit conditions for those banks,” he said.

Calls for higher capital requirements at major banks should be welcomed rather than shunned, he said, since the turmoil that followed the last 18 months of rate increases showed the system is still not as resilient as it should be.

“We shouldn’t have been in a position where rate hikes to 5%, albeit very rapid ones -- it’s not a historically crazy number, that shouldn’t have created financial stability problems,” he said. “That’s a damning indictment of financial stability policy that that has happened. I don’t think we went far enough with Basel III.”