US – Good-bye zero interest rate policy

by: Maritza Cabezas

ENG-2015-11-US.pdf (105 KB)

GDP growth to be around 2.5% in 2016 and 2.3% in 2017
Inflation to reach the 2% target end-2016
Fed to start rate hike cycle in December
Slow pace of rate hikes in 2016 and 2017

US economy ready for a rate hike

US economic growth has been quite decent in 2015. It’s perhaps not as strong as at the beginning of previous rate hike cycles, but slack has been diminishing and this is likely one of the major reasons why we think the Fed will hike in December. Private consumption has been driving growth this year. A robust labour market and cheaper gasoline prices are giving consumers an impulse. Meanwhile, business fixed investment has been growing at a moderate pace, despite the weaker capex in the energy sector, due to low oil prices. As for net export growth, this has been at best neutral for growth this year. This is the result of the slowdown in emerging markets, particularly China and the strong dollar. In the coming years, we expect GDP growth will grow at somewhat-above-trend rates, mainly driven by rising consumer spending.


Consumer spending to remain robust…

Lower oil prices are contributing to higher disposable income and this should be a support for consumer spending for some time. On top of this, a robust labour market and increasing wealth effects from rising house prices have also been supportive. However, at the beginning of the year, consumers preferred to save. The personal savings rate increased from 4.6% in August to 5.4% in the first quarter, but has been slowly declining since then (4.8% in September). In the past two quarters, this has been changing and we expect consumer spending to remain robust.

…even after rate hike

Indeed, we think wage growth will increase moderately in line with the diminishing labour market slack. We expect that this will offset the reduction in wealth that will occur as the interest rate hike filters throughout the economy.

Investment needs confidence boost

Housing activity has been showing some expansion in the past months. Residential investment growth, for instance, is consistent with a recovery of the housing market. However, forward looking data, including housing starts and permits have been mixed. Meanwhile, non-residential investment has been a bit below expectations and there are downside risks, if oil prices fail to regain their footing as we expect. Lower oil prices are already resulting in a contraction of energy-related investments. Indeed, in the past few months structure investments has sharply declined. On the other hand, equipment investment has been stronger, but below expectations. We think that there is some room for an improvement in investment growth. A rate hike will do more good than harm to business sentiment. It will confirm that the economy is solid enough to support a rate hike, boosting investor sentiment. We are forecasting that residential and non-residential investment will slowly improve in the coming years, on the back of a decent economic outlook coupled with only a slow pace of rate hikes after the lift-off.

Weak export growth… the worst is over

Since the end of 2014, net trade has been a drag on growth. This is partly explained by slower global trade growth and a stronger US dollar. Indeed, the trade weighted value of the US dollar, one of the metrics which compares the exchange rate of a country against that of its major trading partners has appreciated by 13% over the past year. This represents a loss of competitiveness for US exporting firms. According to the S&P Dow Jones indices, about 40% of US firms’ revenues comes from abroad. Manufacturing activity, which accounts for a large chunk of US exports, has been feeling this pressure, hurt also by the impact from the contraction of energy-related investment. As the global economy grows a little bit faster in 2016 and 2017 than currently, we expect this to offset some of the impact of a stronger dollar on trade. At least, we expect net trade to be less of a drag for the economy in the coming quarters.

Inflation, looking beyond lower oil prices…

A concern this year has been whether the decline in oil prices and a stronger dollar will prevent inflation from making progress back towards the Fed’s inflation goal. Indeed, inflation has been running far below the 2% target. Headline inflation has fallen by 2ppts since oil prices began their decline. Under the current circumstances, we find it is more appropriate to focus on core inflation to assess any potential risks of inflation falling too far below its 2% target. Core inflation, which excludes food and energy has been trending up recently. This is the result of higher prices of services (medical services, professional care and recreation). The rise in disposable income has increased the demand for services. This has offset the fall in prices of goods, which have been pulled down by a strong dollar and lower transport costs. We see the impact on inflation of falling oil prices as temporary, that is as long as oil prices stabilise at some point.

…and more into diminishing slack

The pace at which inflation will increase will depend on diminishing slack in the economy. Labour market slack has been rapidly diminishing. So far this year, total nonfarm payroll employment has been expanding at an average of around 200K. The unemployment rate is now at 5%, close to the rate of 4.9% that is considered consistent with inflation at 2%. Rising wage growth would be a signal that the labour market is getting closer to achieving its employment mandate. We think that we may be getting closer to the turning point in wage growth. There is more evidence that certain businesses are facing increasing challenges in hiring and robust job turnover continues to show increasing momentum in the labour market. Expectations of low inflation will be challenged, if wage growth starts picking up. We expect the core measure of inflation targeted by the Fed to increase gradually in the second half of the year, reaching the 2% target in 2016. This is in line with the Fed’s objective.


A cautious Fed at the forefront of the rate hike…

Hence the economy seems to be ready for a rate hike after seven years of near zero interest rates. The normalisation process will take place at a time when other central banks, including the ECB, the BoJ and the People’s Bank of China are easing. Although the mandate of the Fed refers to full employment and price stability, policy divergence has raised concerns about the spill-over effects to the global economy of tighter financial conditions in the US, which is partly the result of a strong US dollar. We think that this has made the Fed more cautious.

… calls for a slow pace of rate hikes to reduce risks

Past tightening cycles suggest that the US economy is generally solid at the time of the lift-off and that inflation is trending up. This time, fundamentals of the US economic activity are solid and, in time, should lead to a pick-up in growth and inflation. Nonetheless, the current soft inflation and as already mentioned the recent financial stress call for a slow pace of rate hikes. But there are other reasons that support a gradual pace of rate hikes. The market-implied probability of a rate hike in December has increased since the October FOMC meeting this year, but around a quarter of investors still expect a later rate hike later than December. To avoid surprises, communication of a soft path of rate hikes in December may reduce potential stress in financial markets. Moreover, within the FOMC, despite the differences in the timing of the rate hike most seem to agree on the slow pace of rate hikes thereafter.

Our view on the Fed’s normalization policy

We think that after the lift-off in December, the pace for rate hikes will be slow. Indeed, the divergence in policies across central banks and financial tightening in the US requires a cautious approach to ensure that the actions do not result in unnecessary tensions. We expect the Fed policy rate (the interest rate on excess reserves or IOER) to reach 0.5% in December 2015. Then the next hike will be in June, giving the Fed a bit more time to assess the impact for the US economy and thereafter hikes every other meeting reaching 1.25% at year-end 2016.

This article is part of the “Global View” of 25 November 2015.