What's the Fed's next move on US interest rates?
The minutes of the Fed’s last meeting have increased the likelihood of a June rise in US interest rates, indicating that the FOMC is warm to the idea of a hike sooner rather than later. But what are the economic conditions that have to be met to prompt a rate hike? And what would be the impact of a rise on the world economy?
The last time the board of governors of the Federal Reserve Bank met on 26–27 April they decided to leave the federal funds rate at its current level of 0.25%–0.50%. The FOMC noted that since the financial crisis a series of supervisory policies and regulatory practices has helped stabilise the financial system and mitigate the effect of major shocks on the financial markets.
The US, however, lacks many macroprudential tools and institutional factors may make it difficult to implement such tools in a timely fashion, thereby diminishing their effectiveness in times of crisis. During Q1 2016 the FOMC pored over the economic data and decided that conditions in the labour market had improved, despite a slowdown in real GDP. However, inflation remained below the Fed’s long-term objective of 2%. This was largely due to the impact of weakness in the energy sector, brought about by oversupply and slack demand. Overall, the Fed decided to maintain interest rates at their current level.
Where the US economy stands in the lead-up to June
Developments in Q2 2016 have brought about a change to a more hawkish tone from Fed chair Janet Yellen, Stanley Fisher and other ranking policymakers. Various Fed officials have intimated that the delay in raising interest rates was beneficial to the US economy given the tightening that has taken place during the first quarter, as economic growth slowed down to its lowest level in two years. As it stands, New York Fed president, William C Dudley, said that a degree of tightening in financial conditions is appropriate, and is to be expected with quantitative tightening.
On Wednesday 18 May, minutes from the last Fed meeting indicated that a June rate hike is a possibility: provided GDP meets or beats consensus forecasts momentum for a rate hike will grow. All eyes will be on the June 6 speech by Janet Yellen prior to the Fed’s next decision. Domestic and international factors that may determine the likelihood of a rate hike include:
- A strengthening of US labour market conditions
- US inflation moving towards the 2% target objective
- Speculation over the UK’s referendum on EU membership
- Global repercussions of China’s management of the renminbi
Of particular significance, this Friday (27 May) the second estimate of US GDP for Q1 2016 will be announced. The first estimate for Q1 gave an annual growth rate of 0.5%, down from 1.4% the previous quarter, but analysts expect an upwards adjustment to 0.9%.
The economic consequences of higher interest rates
Rate hikes have important consequences for the US economy, with a wider global impact. A increase to 0.75% would cause an appreciation of the US dollar, while we would expect to see a decline in business and consumer spending. Equally, this could have a negative impact on US equities, as reduced levels of investment affect earnings.
Additionally, a strong US dollar can be bad for homegrown business as it increases the real cost of US exports. Dollar-denominated commodities such as gold, crude oil, copper and iron ore also suffer when the US dollar is strong relative to its peers. The Fed will take all of these factors into consideration when making its decision on June 14–15 2016.
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