Interest rates just rose, and they could rise more next year

23 Dec 2015 | Author: | No comments yet »

The Fed has acted – now it is the Bank of England’s turn.

And given the Fed’s promise of a gradual path ahead, the real test will not come until later next year when its forecasts are tested. “Generally if you’re in an interest rate tightening cycle, it’s because you’ve got better economic conditions,” says fund manager Darren Thompson from Northward Capital who holds stocks such as Brambles and James Hardie, both of which are linked to the US economy. “We think overall they’re good businesses at decent valuations, but also the environment is robust enough to support their business and help them grow.” In domestic equities, expectations were reset after the correction in August. The rise that finally did take place on Wednesday was well signalled to markets that cheered the rise, with Dow, Nasdaq and the S&P all climbing on the day by more than 1%. The so-called ”dot plots”, which show the interest rate forecasts of all 17 attendees at the Federal Open Market Committee meeting, suggest that there will be four more rate rises in 2016.

The latest signals from the Bank of England’s Monetary Policy Committee (MPC) have indicated that we should not expect a rate rise in the near future. Recent statements from Mark Carney and his deputy, Minouche Shafik, have reinforced the view that the UK will not be in a hurry to follow the lead of the US Fed.

We know this because the Fed, unlike the Reserve Bank of Australia, issues forecasts for the targeted level of interest rates years in advance based on its internal survey. In the period since the onset of the great recession every central bank that raised rates, including those in Sweden, Denmark, Canada, Switzerland, New Zealand and Israel were forced to reverse course when their economies slowed and it became clear that they had raised too soon.

The latest Reuters poll of economists indicated that the first UK interest rate rise would take place in the second quarter of 2016 (April to June) – so could be only a few months away. The median forecast by Fed participants is for a Fed funds rate of 1.375 per cent by December 2016 but traders are only seeing rates rise to 0.835 per cent. “An early Fed tightening cycle – apart from 1994 – needn’t kill the equity bull market, it’s only in the latter stages when inflation is picking up,” says David Bassanese, chief economist at Betashares Capital. That’s because corporate earnings benefit from the early stages of a cyclical upswing while borrowing costs are still low. “The Fed is like a double-edged sword – on the one hand it’s raising interest rates which adds some risk because it pressures valuations in the equity market and the US housing market. But it also helps reload the cannon in the sense that if you think the economy is good, it gives them scope to respond to another crisis down the track. “Unlike our central bank, they seem to feel less compulsion to worry about potential asset price bubbles. My main concern is that it is especially hard to understand the rate rise,given that the Fed has a dual mandate – to maintain stable prices and to maximise employment.

If the RBA was running the US Federal Reserve and Glenn Stevens was the Fed chair, he would have tightened two years ago.” Some pockets of the market were already looking vulnerable ahead of the Fed decision. The Fed’s inflation target of 2% uses the price index for personal consumption expenditures (PCE), which has been around 0.2% for the past year, due only partly to a steep decline in crude oil prices. Growth and inflation in both the UK and US are also projected at similar rates, with GDP rising by between 2pc and 2.5pc and inflation moving back up to 2pc as the impact of lower oil prices drops out of the calculation.

Unfortunately, inflation expectations may continue to decline over coming quarters, especially if actual inflation remains subdued or drops even further. My Dartmouth colleague Andrew Levin, who was an adviser toJanet Yellen and Ben Bernanke, has suggested, and I agree, at this juncture it is imperative for the Fed to reframe its policy strategy and shore up the credibility of its inflation target. One way of doing that would be to de-emphasise the role of inflation forecasts, which have been persistently wrong over the past few years and instead to link the timing and pace of policy normalisation to actual outcomes for inflation and employment. France continues to be a drag on European growth, but this is offset by better performance in other countries in northern Europe, such as Poland and Sweden.

There has also been a rise in underemployment – measured by the number of workers who are part time for economic reasons – and this remains well above pre-recession levels. And there are signs that these are feeding through into wage increases – for example, pay rates are now increasing by over 6pc in the construction sector.

So UK borrowers and savers should keep a close eye on monetary policy on the other side of the Atlantic if they want to know what is going to happen here.

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