The Federal Reserve should avoid delaying an increase in interest rates longer than is necessary, according to fund managers, as the US economy is now strong enough to withstand this move and central banks in other countries have picked up the baton on supplying liquidity to markets.
In yesterday’s relatively cautious Federal Open Market Committee (FOMC) statement, the US central bank played down recent disappointing news on the health of the US economy and left the door open for a rate hike this year, with some commentators arguing this could take place as soon as June.
The report was published after statistics from the US Commerce Department showed the economy grew by an annualised 0.2 per cent in the opening quarter of 2015, which was below economists’ expectations.
Factors such as extreme winter weather, the fall in the oil price and a strong dollar have been blamed for the slowdown in the world’s largest economy. The Fed’s officials said they expect economic weakness to be temporary after saying the slowdown was partly due to “transitory factors”.
The language in the FOMC statement on interest rates was largely unchanged from the previous month. The statement said the Fed “anticipates that it will be appropriate to raise the target range for the federal funds rate when it has seen further improvement in the labour market and is reasonably confident that inflation will move back to its 2 per cent objective over the medium term”.
Even though the Fed appears to be preparing for the first rate increase, it stressed that the pace of increases will be gradual. “Even after employment and inflation are near mandate-consistent levels, economic conditions may, for some time, warrant keeping the target federal funds rate below levels the committee views as normal in the longer run,” officials said.
Performance of indices over 6yrs
Source: FE Analytics
Rick Rieder, chief investment officer of fundamental fixed income at BlackRock, describes the changes made in the FOMC statement as “modest” but say they shift the balance of probability on the first rate rise towards September.
Although the central bank has not taken a June rate increase off the table entirely, Rieder says the bar for this being the likely timing has been set “quite high”. Requirements on where the bank expects employment and wage to be before the first hike have effectively “moved the goalposts”, in his view.
“Vitally, we think the Fed currently has a window of opportunity to move, with stable markets, longer-term payrolls growth at very high levels (despite the inevitable slowing first seen in March), and foreign central banks (most notably the European Central Bank and the Bank of Japan) taking the reins of policy accommodation,” Rieder said.
“We strongly suggest that Fed rate normalisation will not only be borne well by the economy, but that it may actually hold a positive impact, while keeping rates excessively accommodative almost certainly holds an increased risk for markets.”
“The influence of monetary policy on economic growth and inflation is massively overstated today, and in many respects this degree of ‘emergency’ accommodation has overstayed its welcome. The economy is likely to bounce back in the second and third quarters, and it would be both disheartening and potentially destabilising if the FOMC were to squander this window of opportunity to make an initial rate move.”
Anna Stupnytska, global economist at Fidelity Worldwide Investment, says the FOMC statement “was certainly on the cautious side” and thinks the central bank might not make a move on rates until the end of the year, or even later.
She points out that hopes for economic growth are in part pinned on the US consumer choosing to spend the money they have saved from the falling energy prices of the past few months.
Although this is historically how the US consumer has acted, Stupnytska questions whether the global financial crisis has prompted a “some kind of structural shift in consumer behaviour” that might mean they do not rush out to spend.
Although she suggests this is unlikely, it could be that the Fed will have it in mind and wait until there is a definite acceleration in household spending before moving on policy.
Meanwhile, the economist says inflation and wage growth is likely to be subdued in the months ahead, while the strong dollar will continue to act as a drag on exports and inflation. If this were to occur, the Fed might be reluctant to push up rates given the criteria it laid out in the statement.
“This means the Fed will be able to keep rates lower for longer, with June definitely off the table, in my view, with a September hike remaining a possibility. But given my expectations for how the data will evolve, I think a December hike is more likely, with risks skewed towards 2016,” Stupnytska said.
Paul Ashworth, chief US economist at Capital Economics, has not completely ruled out a summer hike, although he thinks September is more likely.
“We are convinced that both GDP growth and the pace of employment gains will rebound markedly over the next few months. We have already seen a near 1 per cent rebound in retail sales in March. At this stage, however, it would take something quite spectacular to convince Fed officials to raise rates in June,” he said.
“Given the importance of the first rate hike, which would be the first policy tightening in almost a decade, the conventional wisdom is that the Fed would then wait until at least September, which would be the next FOMC meeting with a scheduled press conference.”
However, Ashworth also warns that investors could ultimately be surprised by the pace of rate hikes after the first move occurs – despite signs from the Fed that it plans to move slowly.
“As wage growth and price inflation rebound, we anticipate that rates will rise much more rapidly next year than either the markets or the Fed currently expect,” he said.
