Making sense of the US Fed rate move

IN A widely-anticipated move the US Federal Reserve (Fed) lifted interest rates for the first time in nearly a decade from a range of 0–0.25% to 0.25-0.5%. The Fed also announced an increase in the interest on excess reserves (IOER) rate to 0.50% (from 0.25%), in the reverse repo (RRP) facility rate to 0.25% (from 0.05%) and in the discount rate to 1.00% (from 0.75%).

The previous interest rate hiking cycle, which ended in mid-2006, involved 17 rate increases to a peak of 5.25% in a bid to ward off inflation in a firmer growth environment.

This time around, however, the Fed faces conflicting signs of firm economic growth prospects (including a tightening labour market and continued strength in the housing market), while inflation remains disappointingly low.  

Chart 1: Market probability of a rate rise increased to c.80% in the run up to the December meeting

 


Source: Bloomberg, Momentum Investments

As such we expect the pace in subsequent rate hikes to remain dependent on continued progress in the US labour market, a sustainable rise in inflation and healthier levels of global demand. The US unemployment rate has dropped from 10% in late 2009 to levels typically regarded as full employment or the non-accelerating inflation rate of unemployment (NAIRU).

At an unemployment rate of 5.0%, employers are facing a tougher time filling job vacancies. According to Deutsche Bank, it currently takes an average of 28 days to fill a vacant job, up from 15 days in 2009 and the highest on record since 2001.

As a result of diminishing slack in the labour market, employers were expected to bid up wages. Nevertheless, wage growth has been slow to rise, despite income expectation surveys pointing to further projected gains in wages. Aside from obvious signs of wage pressures building, overall headline inflation has further been impacted by tumbling commodity prices and a stronger dollar which has led to import price compression. A firmer dollar has also led to tighter financial conditions (see chart 2) which has acted as a drag on growth. According to Goldman Sachs, the tightening in the financial conditions index could result in a drag of up to 0.8% on GDP growth by 4Q15.
     
Chart 2: A firmer US dollar has led to a tightening in the financial conditions index

     


Source: Bloomberg, Momentum Investments

The extent to which rates can rise over the next year also depends on the health of the global economy as Federal Reserve Chair Janet Yellen pointed out at the September 2015 meeting in response to weak growth in emerging markets (EMs) and financial market volatility. With emerging markets accounting for 39% of global GDP in nominal terms (and 52% in PPP-adjusted terms), a weak EM growth environment could negatively impact global demand and US GDP further down the line.

Nonetheless, stable survey-based inflation expectations and reassuring strength in consumer drivers support our view for a further three interest rate increases of 25 basis points each over the course of 2016. This is broadly in line with the Fed’s median expectation for four interest rate hikes over the course of next year. The Federal Reserve Bank of Philadelphia’s Survey of Professional Forecasters suggests that although inflation in the current year is expected to track below 1%, longer-dated inflation projections (one and two years ahead) point to headline inflation expectations remaining marginally above the Fed’s 2% target (see chart 3).

Chart 3: Longer-dated inflation expectations remain above Fed’s 2% target


Source: Bloomberg, Momentum Investments

The dovish statement that accompanied the decision to hike interest rates emphasised the importance of upcoming inflation readings and continued concerns over financial and international developments (i.e. whether or not the US economic recovery is resilient enough to withstand the headwinds from a weak global economy).

While the Fed’s economic projections with regards to GDP and unemployment improved marginally (see chart 4 and 5), there was a slight deterioration in their short-term inflation estimates (see chart 6 and 7). The Federal Open Market Committee (FOMC) expects that “economic conditions will evolve in a manner that will warrant only gradual increases in the federal funds rate” and further stated that “the federal funds rate is likely to remain, for some time, below levels that are expected to prevail in the longer run.”

Chart 4: Fed’s real GDP growth projections (%) improved for 2016 and remained steady at 2.0% in the longer term

Source: Federal Reserve, Momentum Investments, dot = mid-point of central range

Chart 5: Slight improvement in Fed’s unemployment projections (%), while the median estimate of NAIRU (structural unemployment rate) remained unchanged at 4.9% in the longer run
 

Source: Federal Reserve, Momentum Investments, dot = mid-point of central range

Chart 6: 2016 PCE inflation outlook deteriorates, but Fed still reasonably confident that inflation will return to the 2% target over the medium term (%)

Source: Federal Reserve, Momentum Investments, dot = mid-point of central range

Chart 7: Slightly lower core PCE inflation outcome anticipated in 2016, but Fed expects core PCE to reach 2.0% by 2018

Source: Federal Reserve, Momentum Investments, dot = mid-point of central range

This dovish sentiment was echoed in the further move lower in the median dot plot of the FOMC members’ rate hike expectations (see chart 8 and 9), edging ever closer to the more benign view of the market. The median Fed expectation for the equilibrium interest rate (the rate ultimately consistent with stable growth) remained at 3.5%, which we deem as still too high given that potential growth is likely to be closer to 2% than the c.3% rates observed historically.

The statement stressed that future interest rate decisions will continue to be shaped by data. If inflation remains low, policymakers would likely proceed more cautiously with rate increases, resulting in the federal funds rate peaking at a lower neutral rate. Yellen confirmed this point in the Q&A session, stating that if the shortfall in inflation does not disappear in response to a tightening in labour markets, the Fed could indeed pause mid-cycle.

Chart 8: Fed members’ median rate expectation at year end has once again shifted lower for the next three years, but remains at 3.5% in the longer run

Source: Federal Reserve, Momentum Investments

Chart 9: Fed dot-plot shifting lower and moving closer to market expectations

Source: Bloomberg

Higher US interest rates to keep emerging market currencies under pressure

Although emerging market currencies, including the rand, initially strengthened on the back of the announcement of the Fed hike (most likely as a result of the dovish nature of the statement), further tightening by the Fed could still trigger further capital outflows in upcoming months.  According to the International Monetary Fund, EMs received up to $4.5 trillion in gross capital inflows between 2009 and 2013. However, data from the Institute of International Finance (IIF) shows that capital outflows to the order of $250bn were observed over 2014.

Higher interest rate prospects in the US could see capital flows accelerate away from EMs, exacerbating funding concerns for those economies heavily reliant on foreign flows to fund fiscal and current account deficits. Apart from being exposed to potentially tighter financial conditions as a modest Fed hiking cycle gets underway, net commodity exporting regions, including South Africa, are facing the headwinds of a less commodity-dependent Chinese growth trajectory and a firmer US dollar.

An additional threat has arisen in emerging markets. According to the Bank of International Settlements, EM borrowing has doubled in the recent five-year period as EM corporations ramped up debt levels when the cost of borrowing was more favourable. Any local currency devaluation triggered by a reversal in capital flows could worsen the debt burden faced by key EMs going forward.  

Poor political decisions domestically further weighing negatively on the SA rand

SA was among those economies that benefited from a prolonged period of ultra-accommodative monetary policy. However, with slow progress on economic reform and sluggish private investment further denting trend growth prospects, SA finds itself ill-prepared for global financial tightening as we continue to face a wide fiscal deficit and rising external financing vulnerabilities.

With SA still reeling from damaging cabinet moves, downtrodden investor confidence will likely prevent the rand from retracing meaningfully on a sustainable basis. The raised likelihood of a sovereign downgrade to junk status suggests that the rand will remain under pressure in upcoming weeks particularly as rating agencies and investors alike look to the February national budget for further guidance on SA’s ability to adhere to its fiscal consolidation timeline and prevent a further acceleration in the debt ratio.

Although the rate of currency pass-through has surprised to the downside, a further weakening in the rand remains as a key source of upside risk to the inflation profile. The SA Reserve Bank (SARB) has warned on numerous occasions that with inflation expected to average close to 6% in 2016, any sustained depreciation in the currency could see inflation breaching the target band for a more extended period of time. A marginal uptick in inflation expectations, as surveyed by the Bureau of Economic Research, has in addition contributed to higher risks of second-round inflation.

As a result, we expect further interest rate tightening by the SARB in early 2016 to maintain credibility in SA’s inflation targeting regime.

Table 1: Shift in key variables between the latest Fed meetings


Source: Bloomberg, Momentum Investments (more dovish for rates, more hawkish for rates)

Language shift in the statements between the October and December meetings

  • A range of…labour market indicators…slowed  → labour market indicators shows further improvement and confirms that underutilisation of labour resources has diminished appreciably
  • Some survey-based measures of longer-term inflation expectations have remained stable → have edged down
  • Appropriate monetary accommodation gradual adjustments in the stance of monetary policy
  • Sees risks to outlook for economic activity and labour market as nearly balanced as balanced
  • Economic activity and labour will expand at levels consistent with dual mandate economic activity and labour will continue to strengthen
  • In light of current shortfall of inflation from its 2% target, Committee will carefully monitor actual and expected progress towards its inflation goal
  • Economic conditions will evolve in a manner that will warrant only gradual increases in the federal funds rate
  • Federal funds rate likely to remain, for some time, below levels that are expected to prevail in the longer run
  • Anticipates reinvesting principal payments and rolling over Treasury securities until normalisation of the level of the federal funds rate is well under way…should help maintain accommodative financial conditions

* Sanisha Packirisamy is chief economist at MMI Holdings.

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