The US Federal Reserve finally bites the bullet, increasing the FFR – a key short-term interest rate – by quarter of a per cent. With this, the regulator has clearly signaled that it might take similar actions in future, if need arises, to take the economy towards full recovery.

1. The Global Analyst | JANUARY 201626 |
INTERNATIONAL / BANKING
FED BITES THE BULLET
Implements First Rate Hike in Nearly a Decade
The US Federal Reserve finally bites the bullet, increasing the
FFR – a key short-term interest rate – by quarter of a per cent.
With this, the regulator has clearly signaled that it might take
similar actions in future, if need arises, to take the economy
towards full recovery.
- Dr. IVO PEZZUTO
Global Markets Analyst, Management Consultant, Economics and
Management Professor
Author of the Book “Predictable and Avoidable” ISTUD Business School and
Catholic University of the Sacred Heart. Milan, Italy

2. 27The Global Analyst | JANUARY 2016 |
US ECONOMY
I
n the absence of unexpected severe externali-
ties, tail-risks, or new unexpected negative data,
it seems quite likely that the US Federal Reserve
(Fed) Bank will continue its monetary policy tight-
ening in the coming months and years after the
first lift-off (since 2006) of the benchmark interest rate
on December 16th, 2015. The banking sector regulator
has increased interest rates (technically known, FFR or
Federal Funds Rate - the benchmark short-term financing
cost for banks that influences a wide range of borrowing
rates for households and businesses) by 25 bps or quar-
ter of a per cent. As a result, its target rate now stands
revised to 0.25-0.50 per cent, from 0-0.25 per cent range.
“Given the economic outlook, and recognizing the time
it takes for policy actions to affect future economic out-
comes, the Committee decided to raise the target range
for the federal funds rate 1/4 to 1/2 percent,” the regulator
said in a press release justifying its action, which comes
after nearly a year of speculations on part of the market
participants and much dilly dallying by the Board itself.
In spite of the modest pace of expansion of the US econ-
omy in October and November recently reported by
the Fed’s Beige Book, and the opinions of some skepti-
cal analysts about the future economic growth of the US
economy, Federal Reserve Chair Janet Yellen is optimistic
about her country’s substantial recovery from the Great
Recession.
A positive move
The US third quarter 2015 GDP was at 2.1 per cent while
the second quarter 2015 GDP was at 3.9 per cent. The
slowdown in the third-quarter real GDP primarily re-
flected a downturn in inventory investment and slow-
downs in exports. The Bureau of Labor Statistics recently
reported that nonfarm payrolls increased in November
2015 by 211,000 jobs (based on seasonally adjusted data).
The recent jobs growth data which is lower than previ-
ous month (298,000 jobs), however, it is exceeding econo-
mists’ expectations of 200,000 jobs. According to Janet
Yellen, the 12-month average job gain after the Novem-
ber jobs report was 220,000, while the participation rate
increased slightly to 62.5 per cent. She believes that the
US still remains below full employment even though for
the majority of analysts and economists the Fed’s interest
rate lift-off decision was already priced in by the finan-
cial markets weeks before the FOMC’s December meet-
ing. In early December 2015, in fact, futures markets at-
tached roughly an 80 per cent probability to a possible
short-term interest rates hike at the policy-setting Federal
Open Market Committee meeting of December 15-16.
At the beginning of December 2015, she had expressed
a firm optimism about the improved labor market con-
ditions (i.e., unemployment rate remains at 5 percent,
down from the 10% peak of October 2009) which boost a
rise in wages and consumer spending (i.e., average hour-
ly earnings rose 0.2 per cent from October and 2.3 per
cent on an annual basis), and overall, should allow the
US economy to withstand the rise in the central bank’s
official interest rate.
In fact, Janet Yellen believes that, in spite of the current
subdued inflation, price levels will soon move back to the
2 percent objective over the medium-term. Headline in-
flation is very close to the 2 percent inflation target, while
core inflation (stripping out the volatile unprocessed
food and energy prices) still remains well below target.
Yet, according to Janet Yellen, moves in the energy mar-
ket prices are transitory in nature and affected by pres-
sures from low oil prices and a stronger dollar, thus most
of the effect should taper off after a few quarters. She also
expects that the headline inflation target will be eventu-
ally reached as further improvements in the labor market
conditions will probably fuel additional growth, inflation
expectations, and consumer spending.
Yet, inflation remains below the Fed’s stated 2 percent
target and core PCE (personal consumption expendi-
tures) in the third quarter rose below the Fed’s stated tar-
get, nevertheless, it is quite evident that the Fed Reserve
in December 2015 was eager to get off the zero lower
bound, as interest rates close to zero per cent evoke an
emergency policy setting that has been in place since the
depths of the financial crisis. Furthermore, zero lower
bound interest rates encourage liquidity traps and may
contribute to generate asset prices’ bubbles and potential
‘boom-bust’ market scenarios (i.e. massive leverage strat-
egies facilitated by excess of liquidity and cheap funding
guaranteed by central banks which allow corporations to
lever up their balance sheet and to conduct stockholder-
friendly actions, like buying back stock or paying divi-
dends, thus artificially inflating the profitability of their
businesses – earnings per share).
End to monetary stimulus?
Since the 2008 financial crisis, the massive injections of
liquidity and cheap funding by the central banks have
contributed to the unusual expansion, growth, and prof-
itability of the financial sector (i.e., the Fed’s non-conven-
tional expansionary monetary policy helped fuel a surge
in the stock market), more than to the recovery of the real
economy, as investments in firms’ capital expenditures
have grown proportionally less than those in the stock
markets, financial sector, and shadow banking business.
In the US, the Fed has undertaken massive unconvention-
al measures to drive down long-term interest rates and to
encourage more borrowing and investments. These mea-
sures have significantly inflated the Fed’s balance sheet
over the years. Thanks to the quantitative easing (“QE”)
programs, the Fed has increased its balance sheet to over
$4 trillion — five times its pre-crisis size.
The austerity measures undertaken by several countries
after the global financial crisis to restore economic and
financial stability, combined with higher tax burden,
budget discipline and fiscal consolidation programs, re-

3. The Global Analyst | JANUARY 201628 |
duced public spending and private
firms’ investments, and the “Great
Recession,” have further enhanced
the divergence between the pace of
expansion of the financial sector ver-
sus the real economy. Furthermore,
structural changes in the technologi-
cal environment, innovative produc-
tion processes and business models
(i.e. smart technologies, disruptive
technological innovations, robots,
digital business models), and the
dominance of the service sector over
manufacturing and other sectors
have also partially contributed to the
reduction of investments in the more
traditional labor-intensive sectors.
Christine Lagarde, the managing di-
rector of the International Monetary
Fund, made the following remark
at the annual IMF and World Bank
meeting in Washington on Octo-
ber 12, 2014: “With regards to the
disconnect between economics and
markets, there is “too little economic
risk-taking (e.g. capital expenditures
and lending), and too much financial
risk-taking.” (Lagarde, 2014)
The scenario for future oil prices,
which has an important impact on
inflation expectations, however, at
the beginning of December 2015,
remains still quite complex and un-
certain since the OPEC aims to stick
with its year-old policy, as the largest
oil exporter, Saudi Arabia, remains
committed to maintaining crude
production to retain market share in
order to compete with big produc-
ers outside OPEC. This strategy will
probably continue to put pressure on
the commodity and energy markets
and on cash-strapped oil exporting
countries such as, Venezuela, Ec-
uador, and Algeria and other weak
economies with unpredictable geo-
political consequences. Furthermore,
leading oil exporting countries face
the growing competition from Rus-
sia, Iraq, and quite soon also Iran,
as the embargo might soon be lifted.
Even the US might soon pursue an
oil exporting strategy as a conse-
quence of the lifting of the US ban on
oil exports. For all these major factors
in the early days of December 2015
(the US crude) oil was trading below
$40 per barrel. Furthermore, recently
emerging geopolitical risks have also
put additional pressures on the oil
exporting countries.
A smooth ride ahead for the US
economy!
Janet Yellen also aims to pursue a
‘gradual and smooth monetary pol-
icy’ normalization (although it is not
guaranteed that it will be gradual
and smooth for the global markets!)
before significantly overshooting the
Fed’s dual mandate goals, that is, of
full employment and price stability.
She believes that the pace of mon-
etary tightening is more important
than the timing, and that it is critical
to avoid disrupting financial markets
through delayed and abrupt policy
tightening decisions.
She expects that a pickup in demand
in many advanced economies; the
easing monetary and fiscal policies
in the emerging-market economies,
and a stabilization in commodity
prices, should boost growth pros-
pects of emerging market economies.
One major concern for the Fed has
been the strong dollar, which keeps
inflation low by pressuring on com-
modities prices.
Apparently the US economy seems
to be ready for a gradual tightening
of its monetary policy (i.e., raising
the federal funds rate), and in the
absence of unexpected externalities
and black swan events, it should be
moving forward on a solid footing
towards a full recovery, as indicated
also by the improving economic fun-
damentals and investors’ expecta-
tions. Yet, a number of analysts ex-
pect that the Fed’s monetary policy
tightening might contribute to the
flattening of the yield curve, and
if the current trend of contraction
continues in 2016, the US Economy
might be faced with the risk of a po-
tential price stagnation which could
eventually lead to a downturn in out-
put and inflation.
In fact, the manufacturing contrac-
tion in November 2015 reported by
the Institute for Supply Manage-
ment’s headline index of manufac-
turing activity (ISM), which fell to
48.6 from 50.1 in October (below the
50 mark — which nominally divides
expansion from contraction), indi-
cates that the strong dollar might be
contributing to the disappointing
manufacturing data even though
the services sector continues to per-
form well and the auto sales have
remained robust driven by low gaso-
line prices.
Recently, a number of analysts and
prominent institutions (i.e., IMF,
Fitch Ratings, Moody’s, BIS, the ECB
Financial Stability Review) have
warned about vulnerabilities and po-
tential downside risks for the finan-
cial system stemming from emerging
markets and China which relate to
geopolitical risks, emerging market
US ECONOMY

4. 29The Global Analyst | JANUARY 2016 |
corporate debt and private compa-
nies’ debt sustainability challenges,
slowdown in GDP and secular stag-
nation, rising inequality, significant
amounts of non-performing loans of
banks, growing size of the shadow
banking and off-balance sheet in-
vestment vehicles’ perimeter, firms’
interconnectedness, a widespread
use of synthetic leverage, declining
profit margins, massive corporate
debt downgrades (i.e., more than $1tn
in US corporate debt has been down-
graded this year as defaults climb to
post-crisis highs - Analysts with Stan-
dard & Poor’s, Moody’s and Fitch ex-
pect default rates to increase over the
next 12 months) (Platt, 2015), the fall
of commodity prices, potential rise
in currency volatility, current account
imbalances, and problems in corporate
credit markets. All these factors com-
bined together add up to a substantial
level of uncertainty and potential insta-
bility in the global markets.
The Switzerland-based BIS (the Bank
for International Settlements), in fact,
has recently raised warnings about
potential ‘taper tantrum’ risks for the
emerging markets associated to the
Fed’s monetary policy normaliza-
tion path. Infact, the BIS has reported
the following statement: “Weaker fi-
nancial market conditions combined
with an increased sensitivity to U.S.
rates may heighten the risk of nega-
tive spill overs to emerging market
economies (EMEs) when U.S. policy
is normalized” (BIS, 2015). Gavin
Jackson and Eric Platt of the Finan-
cial Times recently reported that in
the US the “number of companies
defaulting on their obligations is set
to reach the century mark, driven
largely by struggling US shale gas
providers” (Jackson and Platt, 2015).
Joe Rennison and Eric Platt of the
same newspaper also reported that
“the sales of global corporate bonds
have eclipsed $2tn this year, for the
fourth consecutive year”(Rennison and Platt, 2015).
As the author of this article has stated
in previous publications and in the
book titled “Predictable and Avoid-
able: Repairing Economic Disloca-
tion and Preventing the Recurrence
of Crisis”, the aggressive quantitative
easing policies of the past years have
been valuable and necessary non-
conventional monetary measures for
emergency situations, but over a pro-
longed period of time, they have also
contributed to inflating asset prices
and encouraged unrealistic expecta-
tions in the financial markets about a
potential never-ending availability of
cheap money and unlimited liquid-
ity. In fact, these policies have helped
to take advantage of lower interest
rates and have also encouraged ex-
cessive risk-taking on part of inves-
tors in search for attractive yields
in the financial markets (i.e., sover-
eign bonds, high-yield bonds, ETFs,
synthetic products), due also to the
widespread expansion of negative
interest rates.
More hikes in offing?
After all, in spite of the very generous
and accommodative non-conven-
tional monetary policies of the past
years, there is a limit to what central
banks can do to offset global disin-
flationary pressures triggered also
by structural global macroeconomic
forces such as the global slowdown,
falling commodity prices, demo-
graphic differences, the shrinking of
the middle class in a number of west-
ern economies, weak productivity
growth in some countries, reduced
investments in the real economy (i.e.,
capital investments and lending),
and macroeconomic imbalances.
Furthermore, it seems that the ag-
gressive quantitative easing poli-
cies of the past years have also de-
layed the restructuring of distressed
credits and non-performing loans
(NPLs). In addition, as some analysts
argue, massive QEs without proper
macro-prudential policy making, co-
ordinated ad hoc fiscal policies, and
structural reforms, can also contrib-
ute to create a false impression of
liquidity and they may sustain fake
alpha (market outperformance based
on capturing risk premia on hidden
fat-tails). As it is well known, un-
fortunately, too much of good thing
cannot last forever.
Portfolio managers, fund manag-
ers, credit managers, and investors
should remain watchful of these
developments, early warnings, and
potential systemic risks, despite the
improving fundamentals of the US
economy and other economies, since
in a worst case scenario they might
be faced with a sharp and sudden
risk aversion in the markets, higher
levels of volatility, market liquidity
problems, increased capital require-
ments, and strong corrections in as-
set valuations due to these potential
market dislocations.
Let’s hope that the new year 2016
will be a peaceful, prosperous, finan-
cially sound and sustainable one for
the global economy and the financial
markets and that the worst case sce-
nario just described and warned by
US ECONOMY

5. The Global Analyst | JANUARY 201630 |
many analysts and commentators
will remain only a fat-tail risk event,
that is, an extreme, infrequent, and
rare event, since for most countries
the level of SOVEREIGN DEBT and
corporate debt in 2016 will be signifi-
cantly higher than those preceding
the 2008 global financial crisis (i.e.,
approximately 94 per cent in the Eu-
rozone).
The US national debt, for example,
should soon be approaching $19 tril-
lion, thus the leading global econo-
my, just like other economies with
even higher levels of sovereign debt
as a percentage of GDP, seems to
have no choice but to keep interest
rates low for quite a long period of
time. The combination of this condi-
tion (i.e., low interest rates), with the
ongoing accommodative monetary
policies of other central banks, and
a massive recourse to complex and
innovative financial engineering so-
lutions (derivatives and off-balance
sheet investment vehicles) may po-
tentially reduce the perception of
the debt-burden risk in the corporate
world and they may encourage addi-
tional excessive risk-taking practices.
Outlook
To conclude, an energizing wave of
optimism is definitely in the air (es-
pecially following the first interest
rate hike by the Fed in almost a de-
cade) making the financial markets
very excited about the positive eco-
nomic outlook of the US economy
and the future outlook of many as-
set classes in 2016 as a consequence
of the divergent monetary policies
of the Federal Reserve, the ECB, and
other leading central banks and the
impact of structural reforms.
Thus, in the short run things should
move forward quite smoothly, un-
less there will be unanticipated nega-
tive shocks. Yet, with a longer-term
perspective, in spite of the robust
ongoing US economy data improve-
ments, the general optimism in the
financial markets, and a strong inten-
tion of the Fed to start its monetary
policy normalization, some concerns
remain related to the level of global
imbalances, the
global slowdown,
the rising levels of
debt, low inflation
rates, and the po-
tential downside
risks for the emerg-
ing markets, cur-
rency markets, and
global economy.
Looking forward,
complexity and
uncertainty seems
to be rising in the
global markets and
capital requirements (as the author
of this article has already warned
in the paper titled “Predictable and
Avoidable: What’s Next?” of Septem-
ber 2014); the high unemployment
rates in some geographical areas; the
structural macroeconomic imbalanc-
es; the bigger global output gap and
the below target inflation rates; the
global divergence; the potential cur-
rency wars; and in some economies
also the gloomy recessionary trends.
Thus, there is room to be optimistic
about the New Year 2016, at least for
a part of the banking business, since
even with tiny increases in interest
rates over the coming months and
years they expect a real boost to their
revenues on loans and other busi-
ness lines. Markets, however, should
not underestimate the risk of a sud-
den and unexpected rise in volatility
due to a potential turbulence in oth-
er parts of the banking and finance
business or in other geographical
areas of the global markets. Potential
adverse macroeconomic scenarios
and sharp corrections should not be
easily overlooked.
Investors should remain alert of po-
tential unexpected downside risks
and they should engage, as much
as possible, in highly diversified as-
set allocation, security selection,
and portfolio rebalancing strategies.
They should also try to reduce exces-
sive emotional reactions to market
investing and they should try man-
aging their portfolios by adopting a
longer-term investment approach.
TGA
US ECONOMY
economies in the coming years. The
global business environment will
probably face more complexity, in-
terconnectedness, and vulnerability
due to the increased use of innova-
tive digital technologies, innovative
business models, and complex finan-
cial engineering solutions and mar-
kets, which will generate many new
exciting business and employment
opportunities but, one way or anoth-
er, they might also inevitably affect
our countries’ social, economic, and
sustainability models.
In the coming years probably the ma-
jor concerns for the global markets
will be the following: the ability and
commitment of the countries with
high levels of sovereign debt, and
stagnant, and anemic GDP growth
rates to effectively complete the re-
quired structural changes and adjust-
ments in order to achieve sustainable
growth; the challenges of political
and social integration in a number
of countries due to rising nationalist
forces; the international geopolitical
challenges and tensions; the large
number of firms with heavy debt
burden; the rising shadow banking
sector (i.e., Over-the-Counter trading
of derivatives and off-balance invest-
ment sheet vehicles); the potential
threat of highly leveraged invest-
ment funds; the high yield market;
the high levels of banks’ NPLs; the
‘illiquid’ and distressed credit mar-
kets and the high levels of volatility;
the potential risk to financial stability
of reviving the asset-backed securi-
ties markets with lower standards in