Federal Reserve rate rise is imminent

In all probability, the US Federal Reserve will this week announce the first interest rate hike in nine years, taking the Fed funds target rate up to 0.5 per cent from 0.25 per cent. This will come at the end of a year that has had a number of false starts, as the Fed has variously raised expectations of a rate hike only to dash them as the economic data or financial markets have introduced fresh risks. However, with the markets having discounted next week’s move, it is the outlook for interest rates next year that is becoming the more significant issue.

Although the latest decline in oil prices has added some renewed uncertainty into financial markets, it seems unlikely that the Fed will blink next week when it meets to set monetary policy. Aware of the criticism that it has already waited too long to raise interest rates, the Fed will seize on the recent evidence of momentum in the jobs market to begin the first tightening cycle in almost a decade. The question will then become what that tightening cycle will actually look like.

In past interest rate tightening cycles, the Fed has typically set out of its stall to reach a specific destination when it comes to interest rates over a given time period, often hiking on a regular basis at every Federal open market committee (FOMC) meeting until those targets are met. This time around, however, the Fed’s approach is likely to be different and more circumspect. I have spent the past week in the United States meeting investors and market participants, and there appears to be a fairly wide consensus that interest rates will only go up by a little next year, with only one or two increases expected over the course of the year as a whole.

This is because the US economy still looks a long way from producing the kind of inflation that would justify raising interest rates more aggressively. The Fed’s preferred inflation measure only stands at 1.3 per cent, some way below its 2 per cent objective. And despite an unemployment rate of 5 per cent, it does not look as if the labour market is strong enough yet to produce any meaningful upturn in wage inflation, as there is still excess capacity and low levels of investment and productivity. Paul Krugman described the US as the “not-so-bad economy” in The New York Times last week, one that might appear able to justify a rate hike, but that could ultimately turn out to be a mistake.

With oil prices also likely to remain weak in the near term, it may be a stretch for the Fed to justify raising interest rates again before March, and thereafter much will depend on whether the recovery continues or starts to falter. As the Fed has waited so long to raise rates in the first place, the risks are beginning to be tilted towards the latter. Into this mix will also come politics, and with a presidential election looming later next year this may also add to the arguments for the Fed to tread warily, despite being supposedly independent.

The Fed is likely to be cautious when it comes to expressing its outlook for the course of interest rates into next year when it meets this week. It will probably lace the first rate hike with dovish language and lower the trajectory for the peak in interest rates closer to 3 per cent from 3.5 per cent. Markets may even doubt whether this will ever be reached.

However, there is one school of thought that suggests that a rise in interest rates, far from dampening growth, will be just what the US economy needs. According to this argument, inflation has remained low precisely because interest rates have been held artificially low for too long, deterring investment in the real economy and instead promoting excessive risk taking in financial markets. By this logic, raising interest rates may catalyse growth and investment and, in so doing, actually lead to inflation.

This is counter-intuitive to conventional economic thinking, but it does have some advocates at the Fed. One way or another, the coming year should show whether it has any merit.

Tim Fox is the chief economist and head of research at Emirates NBD


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