As 2016 nears the half-way point without seeing a single U.S. interest rate increase, earlier forecasts predicting year-end rates of 1.375% appear unlikely to materialize. What shape will the revised rate hike trajectory take?
For the time being, the Federal Reserve appears to have stepped on the brakes of the cycle of interest rate hikes. In December, the central bank of the world's largest economy raised interest rates for the first time in nearly a decade. At this meeting, the members of the Federal Open Market Committee (FOMC) announced their expectation to raise interest rates four times in 2016.
Source: Financial Times
These projections are now unlikely to materialize. Nearly half a year later, not a single rate increase has taken place. As a result, the second half of the year may now be characterized by only one or two hikes, as the Fed has repeatedly said it plans to normalize monetary policy only gradually. Rates were unchanged at its latest meeting at the end of April.
The vote in the FOMC was not unanimous - the sole dissenter was Esther George, the President of the Kansas City Fed. She opted to raise the target range for the federal funds rate to 0.5-0.75% and also voted this way at the meeting in March. In a speech last week, Ms. George said that rates were currently "too low for today's economic conditions."
Interestingly, her views now appear to be shared by another member of the FOMC - Eric Rosengren, the President of the Boston Fed. In December, analysts described him as dovish on increases - but said last week that there were risks from a prolonged period of low interest rates.
Source: Federal Reserve Bank of Atlanta
Both he and Ms. George believe that higher rates are now more appropriate as the U.S. economy appears to be functioning well. The Fed's preferred measure of inflation is increases in the core Personal Consumption Expenditure (PCE) price, which has trended higher over the last few months and is gradually approaching the Fed's target of 2%.
The improvement in inflation has also been mirrored in job growth. The April non-farm payroll figure was below expectations, but unemployment was unchanged and is now close to the long-run average. The IMF expects growth in the U.S. economy to increase to 2.5% next year from 2.4% this year.
Hence, worries over domestic economic activity may not have influenced the Fed's decision as much as worries over the fact that a rate hike may have amplified global volatility. The FOMC's statement in March contained the sentence that "global economic and financial developments continue to pose risks." This reference to global risks was absent in the April statement but these factors may have been implicitly considered.
According to the FOMC's statement, the weak points in the economy appeared to be sluggish business investment and net exports. Both these factors are heavily influenced by global conditions. Global markets were volatile in the run-up to the Fed's rate hike last year, and thus may have reacted negatively if the Fed had raised rates last month. More clarity may be provided when the meeting's minutes are released, but for now it appears that the Fed may have kept interest rates unchanged because of concerns that a rate hike may increase global uncertainty, which would have negative spillover effects on the U.S. economy.
Interest rates and global spillover effects
The fact that interest rates were kept on hold cheered global markets, and is likely to be a relief for troubled U.S. energy companies. These firms are heavily leveraged, so may be hurt when rates do rise. Emerging market corporations are even more vulnerable, as they have issued dollar denominated debt. Hence, these companies will be hurt by rate hikes, as the dollar is likely to appreciate in this scenario. The pain may be greater if the stronger dollar means that central banks are forced to raise rates when the Fed does, to prevent their currencies from depreciating. Higher rates are likely to lead to slower growth which would make it difficult for indebted corporations to generate enough revenues to repay their debts.
Consequently, the fact that the Fed retained status quo may be a respite for emerging markets. However, this may also be problematic for Japan and countries in the Eurozone, which face sub-par growth and low inflation. The ECB and the Bank of Japan (BoJ) have attempted to use stimulus programs to revive their economies. These central banks hope that accommodating monetary policy will weaken their respective currencies, hence stimulating exports and pushing up inflation.
But these hopes may not materialize if the dollar continues to fall. These three major currencies are viewed as safe-havens by investors. So a fall in the dollar may make euro and yen-denominated assets more attractive. Hence, unlike their counterparts in emerging markets, the ECB and the BoJ may probably welcome higher U.S. rates as the dollar would be likely to appreciate in this scenario.
Nevertheless, rate hikes may not be imminent in the immediate future. The FOMC's next meeting is in June. A recent poll of economists shows that two-thirds of those surveyed do not expect the Fed to hike rates at this meeting. The meeting is scheduled for just a few days before the UK holds its referendum on EU membership. Markets may be volatile in the run-up to the Brexit decision. San Francisco Fed President John Williams has said that the central bank could potentially take the reaction to the referendum into account when formulating its policy.
Hence, worries over spillovers may mean that the Fed holds back again and only acts in September. Even after this point, the pace of rate hikes is likely to be slow, as FOMC members have repeatedly emphasized. This will hopefully mean that global markets and the U.S. economy can gradually prepare themselves to be weaned off the medicine of near-zero rates without relapses.