The Federal Reserve raised interest rates in the US by 25 basis points on Wednesday, to 1.25%. This second rate rise this year – and the fourth in this economic cycle – was widely anticipated, and had been already priced into markets, according to most commentators.
But some were caught off-guard by the more hawkish tone adopted by Janet Yellen, chairman of the Federal Reserve.
While stating that the prospect for the world’s largest economy remained bright, she noted that inflation was running below target. The US main inflation rate slowed to 1.9% in May, compared to 2.2% in April. It is targeted to run at 2%.
“The economy is doing well, it is showing resilience, we have a very strong labour market,” Yellen said. “It’s important not to overreact to a few readings and data on inflation can be noisy. Idiosyncratic factors have held down inflation in recent months.”
However, commentators pointed out that while job gains remain ‘solid’ they have moderated, and this is having an impact on domestic consumer demand. Weaker growth figures from quarter one may also be weighing on the Fed’s decision to trim their inflation forecasts.
This has led to speculation that the Fed will now pause further rate rises, possibly until December. The central bank also signalled its plans to further reduce its quantitative easing programme – although it is clear this may also be put on hold if the economic outlook deteriorates, or inflation continues to fall.
Fed Puts Future Rate Rises On Hold?
Nathan Sweeney, senior investment management at Architas said: “The Fed has set out its expectation of a further rate rise this year, while also signalling its plans to reduce the central bank’s quantitative easing programme.
“However, both of these actions are dependent on the strength of the US economy, which judging by the most recent data is questionable, and the Fed has made its clear its options are open if the outlook worsens.”
He points out that growth was weak in the first quarter of this year, and is not expected to rebound to any great extend during the second quarter of this year. Sweeny adds: “The case for faster rate rises appear to have diminished, thanks to this weaker growth and increasing uncertainty around the President’s fiscal stimulus plans.”
Antoine Lesne, head of ETF strategy at SPDR ETFs, part of State Street Global Advisers said he expected “more clarity” on the Fed’s plans, particularly in relation to winding down QE in September.
Muted Market Response
Lesne said he expected the dollar to remain “within its current range” on the back of this announcement. He said: “This should offer a bit of respite in the tightening cycle. This may also help the US equity outlook after its recent underperformance versus its European counterparts. This is likely positive for emerging market local currency assets too.”
Neil Williams, group chief economist of Hermes Investment Management said this rate hike was “pretty much baked into asset prices” and he did not expect any significant market movements on the basis of this increase alone.
However, if there is a divergence between the Fed predictions and the markets, this could mean further volatility for asset prices. Kathleen Brooks, research director of City Index Direct explains: “The dollar index experienced excess volatility during the speech, but was back it’s the pre-Fed levels on Thursday. What’s most interesting is the disparity with the Fed’s dot plot and the Fed funds futures market. The Fed’s dot plot is expecting rates to rise to a touch over 2% by 2018, however the Fed Funds Futures and the OIS market is looking for a much milder trajectory for US interest rates – suggesting just one further hike in the next year.
“Is the market always right? Not always but this disparity is odd, and could play havoc with asset prices if the market has been wrong-footed and needs to play catch up. This could see a sharp turnaround for the dollar and US yields. However, all depends on the inflation figures: if prices continue to fall in the US then rate hikes and balance sheet normalisation could be shelved for some time.”
Will Interest Rates ‘Normalise’ In US?
Williams said he remained sceptical about whether the Fed would be able to “normalise” interest rates in the near future, and this could have an impact on markets – both in the US and in Europe and the UK.
He said: “It reminds us that the Fed remains the test case for whether central banks can ever ‘normalise’ rates. We expect it to try, but fail – hiking the Fed’s target just once or maybe twice more in future forecast-round month.”
He pointed out that it can take up to 18 months before rate hikes affect consumer spending in full. He said factoring in the effects of delayed tax cuts, potential protectionism and cold winds elsewhere should mean a ‘peak’ rate of under 2%. “This is significantly lower than the historical average of 5%. Thus we may be facing another two years or negative real policy rates in the UK and UK.”
