Monday, March 30, 2015

US rates to rise only gradually - Yellen

In a speech delivered over the weekend US Federal Reserve Chair Janet Yellen reaffirmed the likely start of US interest rate hikes this year and an only gradual pace of increases thereafter.  There’s not a lot new in that but the speech makes an interesting read in highlighting the FOMC’s thinking about the factors likely to determine the interest rate cycle this time around.

On the outlook for the economy Ms Yellen’s comments were mostly in line with the March FOMC statement.  Lower energy prices continue to get most of the blame for recent inflation weakness with those effects likely to prove transitory.  She acknowledged the impact of the strength in the US dollar in restraining net exports and appears unconcerned about recent weakness in retail sales, expecting consumer spending to grow at a “good clip” this year.  With respect to the labour market she says there has been considerable progress on the maximum employment leg of the dual mandate but “appreciable slack” remains.

On interest rates Ms Yellen says the appropriate time for increasing interest rates has not yet arrived but conditions may warrant an increase sometime this year.  She points out that policymaker cannot wait until they have achieved their objectives to begin adjusting policy.  Leaving interest rates too low for too long risks over-shooting their objectives of maximum sustainable employment and 2% inflation as well as creating risks for financial stability.

Furthermore Ms Yellen stated that neither a pick-up in wage growth nor core inflation are needed before the FOMC decides to begin raising rates.  As I’ve said before, waiting for that to happen may leave the Fed having to play catch-up with more aggressive rate hikes  The Committee “simply”(my emphasis)  needs to believe that conditions are in place for its dual mandate to be met before hiking rates.  That said were core inflation or wage measures to weaken, or were inflation expectations to soften, she would be left “uncomfortable” in raising interest rates.

Ms Yellen is clearly attempting to deflect focus from the timing of the first interest rate increase to the shape of the interest rate cycle.  Indeed the most important aspect of the interest rate cycle for businesses and households is the cost of capital over the cycle, not the timing of the first hike.

In that respect she spends a considerable part of the speech alluding to the reason why an only gradual rise in the Fed funds rate is likely:

  • Firstly, the equilibrium fed funds rate may not recover as quickly as anticipated.  That means the ability of the economy to adjust to higher interest rates is uncertain.  Ms Yellen highlights the experience of Japan with a tightening of monetary conditions when the equilibrium rate remains low has considerable costs.
  • The second factor is the asymmetry in the effectiveness of monetary policy in the vicinity of the lower bound.  While interest rates are expected to move higher as the economy improves, should the economy falter as rates rise, there is limited room to stimulate the economy without resorting to further asset purchases with all the risks that would entail.
  • Third, she makes the observation that a prompt return to the FOMC’s 2% inflation could be advanced by allowing the unemployment rate to decline below its long run sustainable level for a while.

While all of these are valid reasons for the Fed to move only gradually, it wouldn’t be a balanced speech without highlighting the risk of proceeding too slowly, letting inflation get away, thus undermining the Committee’s inflation fighting credibility.  That seems to me to especially relate to the third point above.

In short there’s nothing in this speech to alter our view of a likely September “lift-off” for interest rates in the US and an only gradual removal of monetary accommodation thereafter.  But the speech is a more than useful dissertation of what the Fed is thinking about and what they will be watching as the cycle unfolds and the uncertainties that entails.

Regular readers may recall the point we made before the start of the interest rate tightening cycle last year that to some extent the RBNZ (and markets) were on a voyage of discovery with a number of uncertainties about the post-GFC New Zealand economy including the level of the neutral cash rate, the rate of potential GDP, the level of the equilibrium unemployment rate and how businesses and households would respond to higher interest rates.

Ms Yellen concludes her speech with similar thoughts.  She reiterates the Committee’s decisions will be data dependent, but that “We cannot be certain about the underlying strength of the expansion, the maximum level of employment consistent with price stability, or the longer run level of interest rates consistent with maximum employment. Policy must adjust as our understanding of these factors changes.”  New Zealand’s experience certainly supports that.

Thursday, March 19, 2015

Data Insight: NZ GDP

  • New Zealand’s December 2014 quarter GDP growth came in at +0.8% qoq, bang on market expectations and a little stronger than our own forecast of +0.7%.  Annual growth came in at +3.5% with annual average at +3.3%, the strongest since 2007.
  • The sectoral breakdown was much as expected with strong growth recorded over the quarter in retail trade and accommodation, financial and insurance services and manufacturing.
  • The growth outlook remains one of plusses and minuses.  Plusses will continue to be residential construction (particularly in Christchurch and Auckland), population growth via net migration, still relatively low interest rates, strong business investment on the back of robust confidence and the low cost of capital, strong consumption growth underpinned by strong employment growth and higher real incomes as headline inflation approaches zero and, further out, accelerating average trading partner growth. 
  • The minuses will be the still strong New Zealand dollar (especially against those currencies where central banks are easing monetary policy such as the Euro zone, Japan and Australia), fiscal drag as the Government continues to keep fiscal conditions tight in pursuit of fiscal balance, drought and lower dairy prices.
  • That mix of factors has the New Zealand economy set to maintain growth of around 3% per annum for the next two years.  Compared to our previous forecasts that means we see 3% growth being maintained for longer as interest rates remain on hold for a period of time and we see a more muted than expected decline in the terms of trade.  We expect annual average growth of 3.1% in 2015 followed by 3.2% in 2016.  The cycle then turns down further out as interest rates rise further, we pass the peak in the Canterbury rebuild and the migration cycle turns.
  • For a more fulsome commentary on the outlook for the New Zealand economy and the implications for interest rates and the share market, have a read of our latest New Zealand Insights which you can find here.

FOMC completes shift to data dependence

As was widely expected the FOMC’s March Statement removed “patient” form its forward guidance on the timing of the first increase in interest rates in the US.  The Committee has now completed the shift in its guidance from time dependence to data dependence.

On the whole this morning’s statement was at the dovish end of expectations – at least if the market reaction is anything to go by.  The Committee’s assessment of economic activity was softened somewhat with growth having “moderated somewhat” with weaker export growth mentioned specifically.

The new Summary of Economic Projections (SEP) lowered forecasts for real GDP growth and inflation over the 2015-17 period.  As we expected they also lowered the range for the long-term unemployment rate from 5.2-5.5% to 5.0-5.2%.  With the unemployment rate already at 5.5% it would prove difficult from a communications perspective to persist with zero interest rates with the unemployment rate already at trend.

The Committee stated a rate hike in April was unlikely and they would hike “when it has seen further improvement in the labour market and is reasonably confident that inflation will move back to its 2 percent objective over the medium term”. So an increase in interest rates is coming – it’s just question of when.

Recent inflation data seemed to us to shift the timing of the first rate increase out from June to September as there appeared to be an element of spill-over from  lower fuel prices into core inflation.   At the same time the recent strong labour market data appeared to not completely dismiss the possibility of a June “lift-off”.
We have also been unconcerned about recent weakness in retail sales as stronger employment, hours worked and (albeit modest) wage gains suggests strength in consumer spending in the period ahead.

Today’s press statement appears to shift the balance of probabilities for the first rate hike further towards September (or later?).  But with the Fed now completely data dependent, it’s a case of watch this space... 

Thursday, March 12, 2015

RBNZ March Monetary Policy Statement: Neutral means NEUTRAL

Key points:
  • As expected there was no change in the Official Cash Rate today with the RBNZ leaving it unchanged at 3.5%.  In addition the Bank’s interest rate track now shows a completely flat track, reinforcing its neutral stance.  
  • That said, the interest rate projections are the best part of a year shorter than normal, lopping off the period in which we thought the Bank would show a further modest increase in interest rates.
  • The Bank’s forecasts look perfectly reasonable with their GDP forecasts still modestly higher than ours and with an output gap that is more positive than previously forecast.  Technically that means more inflationary, though their inflation forecasts show inflation remaining below 2% for longer thanks to lower petrol prices.
  • So neutral clearly means NEUTRAL with interest rates on hold for the foreseeable future.  The key paragraph from the policy assessment is as follows: “Our central projection is consistent with a period of stability in the OCR.  Future interest rate adjustment, either up or down, will depend on the emerging flow of economic data.”
  • It could well be that we don’t need interest rates any higher than they are today.  That will require the economy to be able to continue to grow at an above trend rate without generating inflation.   The key data going forward will be the labour market, particularly wages as the unemployment rate continues to track lower.  
  • For more on the outlook for the New Zealand economy and interest rates watch out for the upcoming March edition of New Zealand Insights - coming to your inbox soon.