Thursday, December 17, 2015

Fed lift-off - finally

Following much anticipation the US Federal Reserve raised interest rates this morning, taking the Fed funds rate from a range of 0.0 - 0.25% to 0.25 - 0.50%.  This ends 7-years of zero interest rates and is the first increase in US interest rates since mid-2006. 

The anticipation of the end of the Feds zero interest rate policy has caused considerable angst and volatility in markets.  In the end markets have taken it in their stride with equities up a touch and little change in bond yields.  In fact this is all somewhat reminiscent of the taper tantrums where markets were volatile on the anticipation of tapering, only to deliver a massive yawn when it actually happened.

As we have stated repeatedly, the important story is the likely path of interest rates from here and the terminal rate (i.e. the peak).  On that there were soothing words from the Committee this morning:

“The Committee expects that economic conditions will evolve in a manner that will warrant only gradual increases in the federal funds rate; the federal funds rate is likely to remain, for some time, below levels that are expected to prevail in the longer run.”   

To reinforce the point there was a further small downward movement in the interest rate projections contained within the Summary of Economic Projections (SEP).  The central tendency estimate of the neutral rate came down a touch further to range of 3.3 – 3.5%.  We think there is scope for this to move lower towards our estimate of 3.0% over time.   

At their September meeting the Committee provided a number of reasons why they decided not to tighten at that time.  Chief amongst them was concerns about market volatility reflecting concerns about the extent to which the US and global economies could withstand a period of higher US interest rates.  Today’s move reflects a vote of confidence in the ability of the domestic and global economy to cope with higher US interest rates.

A critical factor for the Committee is getting the right balance between going too early and going too late.  In that respect we think the Fed has made the right move today.  In a domestic environment in which GDP growth is running above trend, the unemployment rate is either at or close to full employment, productivity is low  and core inflation is at 2% (although the breakdown still falls short of what could be described as generalised inflationary pressures), moving interest rates off zero is a prudent move.  In doing so they start to mitigate a potential risk for 2016 in which that combination of factors leads to a stronger rise in inflationary pressures and fears the Fed is behind the curve.

History shows (see post below) that the USD does most of its work in anticipation of rate hikes rather than while interest rates are rising.  But this time the Fed is going it alone as the other major central banks continue to ease including in Europe, Japan and China. 

Various central banks have tried to go it alone and failed over the last few years, including our own.  We think the Fed is probably the only central bank that will be able to get away with that, but it will certainly limit how much they can do given the likely impact on the USD of too great a degree of monetary policy divergence.  That’s good news for asset classes such as emerging markets and commodities that are most sensitive to increases in the USD. 

In the meantime a combination of low core inflationary pressures and the recent strength in the USD has us believing the Committee’s gradual rate rise story.  We expect the federal funds rate will still only be around 1.0 - 1.25% by this time next year.  As the Committee notes, this will of course be dependent on the incoming data.  Watch this space.