Fed rate rise is first step to rebalance US financial system

23 Dec 2015 | Author: | No comments yet »

BoE treads a fine line on rates.

Even after Federal Reserve chair Janet Yellen and colleagues raised the target range for the federal funds rate to 0.25% to 0.5%, that’s still way below its 2% average since 2000 and the 3.2% of 2000 to 2007. • A UK rate rise would hold be likely to hold back household expenditure.Traders work on the floor of the New York Stock Exchange (NYSE) shortly after the announcement that the US Fed…

LONDON (Reuters) – The first U.S. interest rate rise in nearly a decade helps clear the way for a similar, long-anticipated move by the Bank of England. It also means JPMorgan Chase & Co.’s average rate for eight developed nations and the euro-area weighted by size is on course to end 2016 at just 0.36%. But a key question for rate-setters here is whether British households, still scarred by the financial crisis and labouring under heavy debts, will be ready to cope with higher borrowing costs. The Federal Reserve, chaired by Janet Yellen, lifted rates from their historic low of 0.25 per cent to 0.5 per cent, bringing an end to an unprecedented era of monetary easing, which had been put in place to prevent America sinking into another 1930s style Great Depression.

It also marks the beginning of another extraordinary period, where the world’s largest economies will see significant divergence in monetary policy. If the Fed lifts its benchmark to 1.5% a year from now, as JPMorgan predicts, the bank’s economists still see the rate for the key industrial economies undershooting 1% next December as the European Central Bank and Bank of Japan stay on hold. Insofar as the Fed’s move signals the start of a normalisation of rates, it is a positive for banks that have spent the best part of a decade subsisting on punishingly low asset yields. Some economists believe the Fed’s rate hike could also signal a major turn in the global interest rate cycle, meaning the cost of borrowing could start to rise relatively soon for the UK too, pushing up mortgage repayments for millions of British families. The question being asked this morning is how wide this divergence will get and what the implications will be for markets, particularly the currency markets.

Crucially for Carney, it allows him to assess how the U.S. economy and markets react to costlier borrowing before making what will be a sensitive move of his own. In general, banks will be able to charge customers more, and deposit-heavy lenders like HSBC will be able to make more money on their safest funding streams. The British economy is likely to be among the world’s fastest-growing for a third year in a row next year and, just as in the United States, it has seen a drop in unemployment. Still, the good vibes among European banks are just as likely caused by Yellen’s aspiration that any further rate rises in 2016 and beyond will be gradual. It also reiterated that it remains data dependent and said that it would see “actual and expected” progress towards its inflation goal. (One basis point is one-hundredth of a percentage point.) Essentially, the Fed used all the phrases (“accommodative”, “gradual”, “data-dependent”) that the market wanted to hear.

But faced with near non-existent inflation, sluggish wage growth and ultra-loose monetary policy in Britain’s main euro zone trading partners, Carney has already stressed he would not necessarily move in step with his Fed counterpart Janet Yellen. Official statistics released yesterday showed a slowdown in average UK wage growth in the three months to October, one of the key indicators of inflationary pressure analysed by the Bank’s Monetary Policy Committee. After November retail sales volumes (excluding petrol) increased by 1.7% month on month and 3.9% year on year, Berenberg bank said: “Today’s data exceeded even our own long-held bullish view on UK retail.” . To be sure, he sent signals in July that a decision on whether to raise rates for the first time since 2007 could become clearer around the end of this year.

Just over $2 trillion is cross-border debt extended by overseas sources, with over $100 billion granted to Turkish and Chinese borrowers apiece, and a similar amount by Russian banks to domestic creditors. This dot plot, which essentially plots the expectations of US Federal Reserve members, suggests that there could be four 25 basis point hikes from the Fed in 2016. UK households are the second-most-indebted in the Group of Seven advanced economies, with debts equivalent to 156 per cent of their combined annual income, according to the Organization for Economic Cooperation and Development. A quarter-point rate rise is unlikely to send these borrowers into default, but further hikes might, if they make dollars relatively more expensive vis-à-vis local currencies. Nevertheless, the Surrey couple who spent £25,000 on presents, while they may be a little freakish in the context of average figures from the Office for National Statistics, are an indication of the confidence felt among those who have a good job with decent prospects.

Canadian households top the table, with a debt-to-income ratio of 166 per cent; the US ranks fourth on the list at 113 per cent, according to 2014 data. But as his predecessor Mervyn King – who was criticised for responding too slowly to the 2007-9 crisis – found out, the exact timing of any move is a delicate balancing act. Some prominent and respected economists cautioned against a rate rise, warning that the central bank could be on the verge of a serious policy error by tightening monetary policy too early. It may be true that higher interest rates will make consumers think twice before borrowing more cash and spending it on the high street, but what about the manufacturers struggling to make headway against the rising pound.

Carney’s previous hints of a British rate rise have been knocked off course by the twists and turns of the world economy, including the plunge in global oil prices which at one point sent British inflation tumbling to below zero. Britons owe more than GBP1.2 trillion ($US1.8 trillion) in mortgage debt, and many homeowners are acutely sensitive to shifts in BOE policy due to the predominance of adjustable-rate mortgages. ECB projections at its last meeting showed that inflation in the region will continue to undershoot the target for at least the next year, which could necessitate more monetary easing.

The only caveat here is that there appears to be internal opposition to a dramatic expansion in the ECB’s bond buying programme (the decision to expand the programme marginally in December was not unanimous). By contrast, officials at the British central bank have in recent months limited themselves to saying they are watching and waiting to see how the country’s economy performs in the coming months, distancing themselves from clearer signals they sent previously that a rate hike might be coming.

If the BOE officials ratchet up interest rates too quickly households may slash spending, imperilling the central bank’s goal of returning inflation to its 2 per cent target. European bankers may still prefer that to an alternative scenario, where Yellen misjudges the U.S. recovery and is forced to cut rates, as Europe itself did in 2011. The British Chambers of Commerce said bumper retail sales figures highlight “the unbalanced nature of our recovery, which continues to rely excessively on domestic demand and on services”. Giving British exporters some respite, sterling has fallen around 0.6 percent against the dollar since Dec. 1 as expectations for a U.S. rate hike mounted.

Mr Carney acknowledged in a recent speech that sensitivity to rate increases “may be particularly relevant in our still heavily indebted postcrisis economy.” The BOE estimates that close to three-quarters of borrowers would face higher regular repayments in two years’ time if its benchmark interest rate rose to around 1.5 per cent. Given the BOE last raised rates in 2007, many have never budgeted for rate increases. “A big number of households don’t know what a rise in interest rates feels like,” said Mr Garnier, a politician in Prime Minister David Cameron’s ruling Conservative party who sits on a committee that scrutinises economic policy. Economists say that among groups of borrowers who will be most vulnerable when rates rise are low-wage earners, who also face the prospect of planned cuts to benefit payments for working families.

Also among those particularly exposed are so-called mortgage prisoners, who own a home but can’t easily refinance because of their age, poor credit scores, or because their house hasn’t recovered its precrisis value. Matthew Whittaker, chief economist at the Resolution Foundation, a nonpartisan think tank focused on living standards, said that the current combination of low inflation, low interest rates and gently rising wages, means that 2015 might prove a temporary “sweet spot” for household finances. While the big monetary divergence will play out between the big four, emerging markets’ central banks can’t exactly sit back and enjoy a ringside view. Earlier this month Mario Draghi, the ECB president, announced another cut in the eurozone’s interest rate and a six month extension of its asset purchase programme. Andrew Colquhoun, head of Asia-Pacific sovereign ratings at Fitch Ratings, sums it up well. “The real uncertainty remains how quickly rates rise, and to what peak.

An out-turn closer to Fed guidance would be a substantial shock for a region where private sector debt levels have risen rapidly and where capital flows have already started to reverse.”

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