Focus on the United States
28 Aug 2017
By Shadforth Financial Group
The decision to raise rates again in June is consistent with the view that the US Federal Reserve (Fed) is on track for gradual monetary policy tightening. The economy continues to improve with both inflation and the labour market having strengthened over the past year, warranting gradual interest rate hikes.
The Fed increased its interest rate, the federal funds rate, by 25 basis points to a target range of 1.00-1.25 per cent. This was only the fourth interest rate hike since mid-2006 in a period characterised by tremendous monetary policy support in the form of historically low interest rates as well as quantitative easing as a result of the Global Financial Crisis (GFC).
Consumer price index — above 2 per cent until some ‘one-offs’
For the first time since 2014, the consumer price index (CPI) reached the Fed’s target of 2 per cent in December, but has since fallen to 1.6 per cent. The Fed attributes the lower readings to one-off reductions in certain categories of prices, such as wireless telephone services and prescription medication. The fall has coincided with a decline in consumer inflation expectations reported by the New York Federal Reserve which could put a dent in the likelihood of a third interest rate hike in 2017 if inflation is weaker than expected in the second half of 2017. The Fed will therefore monitor inflation developments closely.
The Fed’s preferred measure of inflation is the personal consumption expenditure index (PCE), excluding volatile food and energy prices, which rose to 1.8 per cent in February but has since fallen to 1.4 per cent (see figure 1).
Figure 1: Inflation - moving towards target until recently
Source: Bloomberg 2017, IOOF 2017
Economy close to full employment
On the other hand, the unemployment rate has continued to decline, recording 4.3 per cent in May. As a result, many Fed officials believe that the US economy is at full employment, and this warrants further monetary policy tightening. Also supporting the improving economic picture is employment growth which has been solid and the participation rate which has been relatively steady.
Gross domestic product is promising and likely to hold above the 10 year average
GDP growth has also been supportive of further monetary policy tightening, recording 3.5 per cent and 2.1 per cent in the third and fourth quarters of 2016, above the ten year average of 1.7 per cent. However the first quarter of 2017 recorded a disappointing 1.4 per cent but will likely be revised higher once more comprehensive data becomes available. The Fed has indicated that economic growth appears to have rebounded since the first quarter due to the improving job market, high levels of consumer confidence, expanding business investment and export strength.
Tightening of quantitative easing likely to start this year
Minutes from the Fed’s March meeting surprised markets, indicating that if the economy continued to perform as expected, tightening of quantitative easing could be appropriate this year in order to shrink the central bank’s balance sheet. Many didn’t expect balance sheet normalisation to occur until well into 2018 once the federal funds rate was closer to 2 per cent.
The normalisation program involves reducing the Fed’s holdings of treasury and mortgage backed securities which it built up following the GFC. They’ll do this by ceasing to reinvest the proceeds from these holdings, reducing the $4.5 trillion balance sheet in a passive and gradual manner (see figure 2). This will tighten credit conditions and reduce liquidity.
The balance sheet will be reduced to levels below what has been seen in recent years but higher than before the GFC. Recently, former Fed Chair Ben Bernanke suggested a cut to $2.3-$2.8 trillion and Fed Governor Jerome Powell has suggested $2.5-$3 trillion. It’s difficult to determine how long it will take to reduce to this level, but it’s likely to be gradual in order to minimise market disruption and the rise in bond yields.
Figure 2: Balance sheet likely to reduce over a number of years
Source: Bloomberg 2017, IOOF 2017
A quantitative easing unwind like this hasn’t been seen before but the Fed has announced its intention well in advance. As a result, any surprise to financial markets will likely be limited and will help prevent extreme market moves. Additionally, the Fed believes that using caps will limit the volume of securities that private investors will have to absorb, helping prevent extreme moves in bond yields.
It seems that the US economy is improving, and despite the drop in inflation in recent months, there will likely be a third interest rate hike this year. This is consistent with the Fed’s ‘dot plot’ which indicates their target level for the federal funds rate, currently 1.25-1.50 per cent for 2017.