Bank watches closely as Fed ponders US rise in interest rates
THE Federal Reserve meeting next week will actively consider rai sing US i nterest rates for the first time since the financial crisis. While a hike is unlikely, US economic improvement suggests that a move will soon be in the offing. The Bank of England faces a similar outlook although a UK rate increase is likely only after inflation moves decisively from 0% early next year. Both changes would mark the start of a new post-crisis phase in monetary policy.
Although we do not expect a rate rise next week, the significance of a discussion led by Federal Open Market Committee (FOMC) chairman Janet Yellen no longer constrained by a collapsing economy or forward guidance is highly important. As noted by San Francisco Fed president John Williams: “To be able to even entertain such a move is a tremendously positive sign.”
A June rise looks unlikely, based on the US economy’s soft start to 2015. The economy has stuttered since the start of this year, contracting in the first quarter and posting only mixed evidence of the scale of a rebound thereafter.
Nevertheless, a harsh winter, worker disruption in West Coast ports and technical seasonal adjustment issues all suggest the first-quarter slowdown was exaggerated. However, weaker international economies and the apparent lack of consumer reaction to the oil price- inspired boost to incomes threaten a more-persistent headwind to growth.
As a result, some FOMC members now sound more cautious over the immediate outlook.
Yet a broader view suggests the time for an interest-rate increase is nearing. Erratic quarterly GDP distracts from an economy that has expanded consistently in recent years and sufficiently to bring unemployment back to 5.5%, close to the 5%-5.2% rate the Fed has identified as sustainable in the long run. This reduction in unemployment has also produced the first signs of pay increases. Such wage gains are likely to bolster the Fed’s confidence that inflation is set to rebound from its five-and-a-half-year low of minus 0.2% over the coming quarters.
The Fed requires “reasonable confidence” that inflation will rise in the future before it sanctions a rate rise. Despite mixed economic signals and market expectations to the contrary, we expect the Fed to make its first policy adjustment in September, marking the beginning of a gradually tightening cycle.
If all of this sounds familiar, it should. Bank of England Governor Mark Carney is confronted with a similar debate in the UK. Domestically, growth softened in the first quarter of 2015 but the economy looks well-placed for faster expansion in the second quarter. The UK economy has been buoyant since early 2013 and unemployment is also at 5.5%. This is again close to the Bank’s view of a long-term, sustainable rate, and sufficiently low to have generated the first signs of accelerating pay growth. Monetary policy also remains pegged at an emergency setting. Over the medium term, arguments for scaling some of this accommodation back are rising.
Of course, there are differences between the two economies.
Chancellor George Osborne’s forthcoming Budget looks set to confirm a sharp, fiscal squeeze that the US will not face. Uncertainty surrounding the UK’s EU referendum also looks set to weigh on the domestic economy.
Moreover, the singular, inflation-focused mandate of the Bank’s monetary policy committee presents more of a communication challenge for any rate hike while inflation remains so far below its 2% target.
These factors lead us to expect a later policy change in the UK than in the US. Indeed, there may be additional, tactical advantages for the MPC following a Fed rate increase. A first move by the Fed would help identify any financial market risks associated with a policy change. It would sharpen expectations and prepare markets for a UK rise, and should help avoid a sharp rise in the value of the pound (at least against the dollar). For these reasons, an increase by the Fed in September should pave the way for the Bank to follow suit in February 2016.
If this is the case, the global economy is poised to embark on a new phase. The Fed and the Bank were pioneers of crisis monetary-polic y easing — aggressive rate cuts and quantitative easing. Both central banks now appear close to taking the first tentative steps to post-crisis policy with a gradual shift away from this extraordinary era of central bank policy stimulus.