Fed raises interest rates despite declining inflation
NBK MONEY MARKET REPORT
Last week, the Federal Reserve decided to keep its plans for the gradual normalization of monetary policy unchanged, despite recent weakness in both activity and inflation. The Fed also continued to signal that it plans to raise rates one more time later this year followed by a further three hikes in 2018 and ultimately towards their longer-run 3.0% estimate. Additionally, members outlined the plan towards balance sheet normalization, stating that it intends to start the unwinding process this year if the economy evolves as anticipated.
Meanwhile, US 10-year treasury yields dropped following the Fed’s announcement as recent weak inflation data left investors wondering if the Federal Reserve would be able to hike once more this year. As a result, Fed fund futures are pricing a 16% chance of rate hike in September, indicating doubts over a third hike, which might limit the recent strength in the greenback.
At its latest MPC meeting, the Bank of England provided ahawkish policy signal that they have moved closer to raising interest rates, stating that the bank has become less tolerant towards above-target inflation. The move has surprised the market on the UK policy front and added further to the Sterling’s volatility in the near-term. The BoE’s signal comes as a surprise in the aftermath of the UK’s general election result. The move indicates that the central bank is not overly concerned by the recent political developments.
Meanwhile, recent data in the UK have shown inflation accelerating faster than the central bank projected just last month, with the rate now at 2.9 percent. Citing the pound’s recent decline, the BOE said inflation could overshoot the 2 percent target by more than previously thought. In Asia, the Bank of Japan kept its monetary policy unchanged and has upgraded its economic assessment and signaled that growth is shifting into higher gear in its latest meeting. However, Governor Haruhiko Kurod reassured markets that the BOJ will maintain its massive stimulus program with inflation far from reaching the BOJ’s 2 percent target, despite other central bank’s moving towards gradual monetary policy tightening.
On the currency front, the US Dollar initially gained across the board after the Federal Reserve raised its interest rates. The currency then gained more momentum as initial jobless claims and the Philly-Fed manufacturing index positively exceeded expectations. However, the greenback’s strength was short lived as concerns over subdued inflation combined with disappointing consumer confidence and housing data curbed expectations of a further rate hike, pushing the dollar lower.
The Euro opened the week at 1.1193 and reached a high of 1.1295 against US Dollar. However, the pair dropped as the Federal Reserve increased interest rates for the second time this year and managed to reach a low of 1.1130. The currency closed the week at 1.1197.
The Sterling Pound managed to reach a short lived high at 1.2817 at the beginning of the week. However, weak wages combined with political uncertainty pushed the currency to lose its early gains. However, the currency managed to regain its strong footing amid expectations that the Bank of England could increase rates in the near future. The currency closed the week at 1.2780.
The Japanese Yen closed the week as the weakest major currency as other major central banks start to move towards normalizing their monetary loose policies. The pair opened the week at 110.35 and dropped to low of 108.83 as disappointing inflation data pushed the dollar lower. However, the widening divergence in monetary policy between the Fed and the BoJ pushed the pair to a high of 1.1142. The USDJPY lost some momentum and closed the week at 110.91. On the commodities side, oil prices came off their highs and ended the week in negative territory, as investors continued to doubt whether Opec and its allies’ global agreement to cut production would be able to overcome the glut in supply amid rising US output. West Texas and Brent Crude closed the week at $44.74 and $47.37 respectively.
Fed hikes interest rates as widely expected
The Federal Reserve raised interest rates last week for the second time in three months and said it would begin cutting its holdings of bonds and other securities this year, signaling its confidence in a growing US economy and strengthening job market. In lifting its benchmark lending rate by a quarter percentage point to a target range of 1.00 percent to 1.25 percent and forecasting one more hike this year, the Fed seemed to largely brush off a recent run of mixed economic data. The US central bank’s rate-setting committee said the economy had continued to strengthen, job gains remained solid and indicated it viewed a recent softness in inflation as largely transitory.
The Fed also gave a first clear outline on its plan to reduce its $4.2 trillion portfolio of Treasury bonds and mortgagebacked securities, most of which were purchased in the wake of the 2007-2009 financial crisis and recession. “What I can tell you is that we anticipate reducing reserve balances and our overall balance sheet to levels appreciably below those seen in recent years but larger than before the financial crisis,” Fed Chair Janet Yellen said in a press conference following the release of the Fed’s policy statement. She added that the balance sheet normalization could be put into effect “relatively soon.” The initial cap for the reduction of the Fed’s Treasuries holdings would be set at $6 billion per month, increasing by $6 billion increments every three months over a 12-month period until it reached $30 billion per month. Meanwhile for agency debt and mortgage-backed securities, the cap will be $4 billion per month initially, rising by $4 billion at quarterly intervals over a year until it reached $20 billion per month.
US producer price index stayed unchanged
Producer Price Index for final demand remained unchanged in May. Final demand prices rose 0.5 percent in April and edged down 0.1 percent in March. Year-over-year, the producer price index rose 2.4 percent in May, compared to market expectations for a gain of 2.3 percent and following a 2.5 percent increase in the preceding month.
Meanwhile, the core producer price index, that excludes food and energy, increased by 0.3 percent in May, more than forecasts for a gain of 0.2 percent and compared to the previous month’s 0.4 percent rise. Core producer prices rose at an annualized rate of 2.1 percent last month, compared to forecasts for a 2.0 percent increase and a gain of 1.9 percent in April. Core prices are viewed by the Federal Reserve as a better measure of longer-term inflationary pressure because they exclude the volatile food and energy categories. Moreover, when producers pay more for goods, they are more likely to pass price increases on to the consumer, so PPI could be considered a leading indicator of inflation.
US consumer price index dropped
Consumer inflation unexpectedly decline in May, pressured by lower prices of gasoline and goods. The Consumer Price Index fell by 0.1 percent for the month versus an expectation of a 0.2 percent rise. On a yearly basis, the index rose 1.9 percent in May against a 2.0 percent consensus, while core CPI rose 1.7 percent versus 1.9 consensuses. In the retail sector, the industry recorded its largest drop in 16 months as US citizens cut spending at gas stations, department stores, electronics shops and fewer Americans are buying new cars.
US retail sales fell sharply
Retail sales recorded their biggest drop in more than a year in May amid declining purchases of motor vehicles and discretionary spending, which could temper expectations for a sharp acceleration in economic growth in the second quarter. Retail sales fell 0.3 percent last month after an unrevised 0.4 percent increase in April. May’s decline was the largest since January 2016 and confounded economists’ expectation for a 0.1 percent gain. Year-on-year basis retail sales increased 3.8 percent in May. While some of the drop in monthly retail sales reflected lower gasoline prices, which weighed on receipts at service stations, sales at electronics and appliance stores recorded their biggest decline since March 2010.
EUROPE & UK Euro Area inflation fell
Euro area annual inflation was 1.4% in May, down from 1.9% in previous month. In May 2016 the rate was -0.1%. European Union annual inflation was 1.6% in May, down from 2.0% in April. A year earlier the rate was -0.1%. These figures come from Eurostat, the statistical office of the European Union. The largest upward impacts to euro area annual inflation came from fuels for transport, accommodation services and heating oil, while telecommunications, garments and social protection had the biggest downward impacts.
The Swiss National Bank leaves policy unchanged
The Swiss National Bank left its benchmark interest rate unchanged at record-low levels and reiterated that it is still prepared to take further action to weaken the franc. In a statement, the SNB said it was keeping its benchmark interest rate unchanged at 0.75%, in line with expectations. The central bank also left the target range for the three-month Libor unchanged at between -1.25% and -0.25%. Furthermore, the accompanying rate statement released after the announcement said that “the Swiss franc is still significantly overvalued.” The SNB added that it will “remain active in the foreign exchange market, as necessary,” while taking the overall currency situation into consideration.
Bank of England shocked markets
The Bank of England shocked financial markets on Thursday when it said three of its policymakers voted for an interest rate increase, the closest it has come to hiking rates since 2007, even with signs of a slowdown in Britain’s economy. The surprisingly tight 5-3 vote adds questions over monetary policy to doubt over Britain’s political outlook since Prime Minister Theresa May failed to win a parliamentary majority in an election last week. BoE policymakers Ian McCafferty and Michael Saunders joined previous rate rise advocate Kristin Forbes in voting to reverse the BoE’s decision last August to cut rates to a record-low 0.25 percent.
Financial markets were pricing in a roughly 50 percent chance of an interest rate hike by next June, compared with 20 percent earlier this week. However, many economists said they still saw no rate hike on the horizon possibly for another two years. Britain’s economy slowed sharply in early 2017 as consumers felt the pinch from higher inflation and slowing wage growth. That had led most investors to think it was unlikely that the BoE would quickly follow the lead of the U.S. Federal Reserve which raised interest rates for the second time in three months on Wednesday.