Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 140

Global turmoil likely to make Fed patient

Now that the question of when the US Fed will increase interest rates is answered, the next big question for global markets is how far will they increase rates?

The challenge for those trying to forecast the Fed’s actions in 2016 and beyond is that we are in unchartered waters. Rates have never been at zero before, and the Fed has never increased rates when both inflation and economic growth are so weak.

Fed needs to avoid destabilising

The financial market turmoil in recent weeks adds weight to the argument for the Fed to be more patient. Markets are clearly nervous about global growth, whether it’s in China, Japan or Europe, and the news isn’t bright from any part of the world. Any move by the Fed seen to be constraining for the world’s strongest economy, the US, has the potential to destabilise financial markets further. While the Fed’s mandate doesn’t require them to manage financial markets, any major corrections have the risk of spilling over into the real economy by damaging confidence.

The chart below highlights how different 2016 is to any other interest rate increase cycle. The chart plots each US Fed hiking (increasing) cycle against the inflation and GDP growth figures at the start of that cycle. The larger the circle, the larger the rate increase during the cycle.

What’s happening this time?

The 2015 cycle, kicked off with the rate increase in December 2015, is the only cycle in which both inflation and growth are below average. In fact, growth is lower than the only other cycle in which the Fed has increased rates despite below average growth: the 1980 war on inflation in which inflation was running at 11.2%. And inflation is equal to the lowest of any cycle, but in the other cycle, growth was running hot at 5.6% and so inflation was a significant risk.

So this time it is different. There are two strong arguments suggesting the Fed won’t be in a hurry to increase rates:

1. A weak global economy and raging currency wars

The global economy is weak, and getting weaker. China is clearly slowing, and possibly more than their official data states. The EU and Japan are caught in a multi-decade trap of falling population and imposed fiscal austerity due to their high debt. All three economies are engaging in a currency war in an attempt to make their exports more attractive and boost their economies.

China’s weapon is to lower interest rates to make their currency less attractive, and then devalue their currency. Japan and the EU have zero interest rates already, so they are using massive Quantitative Easing programs to keep longer term rates lower and also make their currencies unattractive.

Lowering one’s currency to make exports attractive works well unless everyone else does it too. Every currency is falling against the US. This puts enormous pressure on the US economy as it weakens their export competitiveness.

This leaves the US Fed in a risky predicament. If the Fed raises rates too quickly or too far, the USD will escalate even further. The Fed will obviously be acutely aware of this and so they will only raise rates further if they have to due to inflation rising above their 2% pa target level.

2. Weak inflation outlook

Central banks’ role is to maximise employment while keeping inflation at or below a stated target level. The Fed’s target rate of inflation is 2%, and it prefers “Core PCE” as a measure of inflation, which is the increase in personal consumer expenditure items excluding food and energy. Using this measure, US inflation is just 1.33% as at December 2015. Add back food and energy, and it is just 0.39%.

Typically, the signal of future inflation risks is wage inflation, i.e. rising wages will typically occur before goods and services’ prices are increased. Wage inflation typically follows a labour market reaching the point at which employers have to compete for labour.

Many commentators have forecast for US inflation to jump in 2015 as the rate of unemployment is well below historic averages. This analysis is flawed as they are looking at the ‘U-3’ measure of unemployment, the measure used in the media headlines and currently 5.0%. But ‘U-3’ simply measures those people without any job, but doesn’t count those in part-time employment that want more hours, or those working for a ‘lesser’ job but seeking better work.

‘U-6’ includes this group and provides an indication of the pool of labour available before employers have to compete with each other for employees and therefore increase wages they are prepared to pay.

‘U-6’ is still well above long-term averages. ‘U-3’ below average simply means that while more people than usual have a job, there is a large proportion of the economy seeking more or better work, and therefore still a lot of slack in the economy.

Without pressure to increase rates, and with the currency wars underway globally, the Fed will be patient. Patience can be interpreted to mean increases will be slow and only if necessary. Looking at historic rate increases, there is no pattern or rule that says the Fed is obliged to increase more than once.

Given we are coming off zero interest rates, it is reasonable to assume that they will want to raise at least 3-4 times during this cycle to give some space to ease again if they have to, but there is nothing to stop them from pausing or even reducing rates along the way. This cycle will be very long and very flat.

 

Craig Swanger is Senior Economist at FIIG Securities Limited, a leading fixed interest specialist. This article is general information and does not consider the circumstances of any individual.

 

RELATED ARTICLES

Will the RBA cut rates before the Fed?

Druckenmiller on the biggest mistake in the history of the Fed

The world's about to hit a brick wall

banner

Most viewed in recent weeks

Meg on SMSFs: Clearing up confusion on the $3 million super tax

There seems to be more confusion than clarity about the mechanics of how the new $3 million super tax is supposed to work. Here is an attempt to answer some of the questions from my previous work on the issue. 

Welcome to Firstlinks Edition 566 with weekend update

Here are 10 rules for staying happy and sharp as we age, including socialise a lot, never retire, learn a demanding skill, practice gratitude, play video games (specific ones), and be sure to reminisce.

  • 27 June 2024

Australian housing is twice as expensive as the US

A new report suggests Australian housing is twice as expensive as that of the US and UK on a price-to-income basis. It also reveals that it’s cheaper to live in New York than most of our capital cities.

The catalyst for a LICs rebound

The discounts on listed investment vehicles are at historically wide levels. There are lots of reasons given, including size and liquidity, yet there's a better explanation for the discounts, and why a rebound may be near.

How not to run out of money in retirement

The life expectancy tables used throughout the financial advice and retirement industry have issues and you need to prepare for the possibility of living a lot longer than you might have thought. Plan accordingly.

The iron law of building wealth

The best way to lose money in markets is to chase the latest stock fad. Conversely, the best way to build wealth is by pursuing a timeless investment strategy that won’t be swayed by short-term market gyrations.

Latest Updates

Investment strategies

Have value investors been hindered by this quirk of accounting?

Investments in intangible assets are as crucial to many companies as investments in capital equipment. The different accounting treatment of these investments, however, weighs on reported earnings and could render ratios like P/E less useful for investors.

Investment strategies

Investors are threading the eye of the needle

As investors cram into ever narrower areas of the market with increasingly high valuations, Martin Conlon from Schroders says that sensible investing has rarely been such an uncrowded trade.

Economy

New research shows diverging economic impacts of climate change

There is universal consensus that the Earth is experiencing climate change. Yet there is far more debate about how this will impact different economies across the globe. New research sheds more light on the winners and losers.

SMSF strategies

How super members can avoid missing out on tax deductions

Claiming a tax deduction for personal super contributions can end in disappointment if it isn't done correctly. Julie Steed looks at common pitfalls and what is required for a successful claim.

Investment strategies

AI is not an over-hyped fad – but a killer app might be years away

The AI investment trend looks set to continue for years but there is only room for a handful of long-term winners. Dr Kevin Hebner also warns regulators against strangling innovation in the sector before society reaps the benefits.

Retirement

Why certainty is so important in retirement

Retirement is a time of great excitement but it is also one of uncertainty. This is hardly surprising given the daunting move from receiving a steady outcome to relying on savings and investments.

Economy

This vital yet "forgotten" indicator of inflation holds good news

Financial commentators seem to have forgotten the leading cause of inflation: growth in the supply of money. Warren Bird explains the link and explores where it suggests inflation is headed.

Sponsors

Alliances

© 2024 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. To the extent any content is general advice, it has been prepared for clients of Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), without reference to your financial objectives, situation or needs. For more information refer to our Financial Services Guide. You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.