Markets May Need Rethink on US Interest Rates

Coins & percentages interest rates image.

06 Feb 2015

Posted in:  Business

The US economy put in a very solid performance over the past three years. GDP grew by 2.3% in 2012, 2.2% in 2013 and 2.4% last year, writesOliver Mangan, Chief Economis at AIB.

These figures, though, mask a marked acceleration in growth since the middle of 2013.Apart from the opening quarter of last year, when some very extreme weather caused an actual decline in GDP, the US economy has grown at an average rate of some 4% for the past 18 months. The recovery in the economy has been quite broad-based, with solid growth in consumer spending, rising business investment, a rebound in housing activity and a good performance by exports.

The strong growth performance has had quite an impact on the labour market.

Employment growth has picked up to 2% year-on-year, reflecting the fact that non-farm payrolls have risen by more than 200,000 in every month since last January.

Labour force growth has been quite sluggish so there has been a marked decline in unemployment. The US jobless rate fell to 5.6% at end 2014. It stood at 7.2% as recently as the autumn of 2013, and is now well below its peak rate of 10% reached at end 2009. Inflationary pressures, though, remain very subdued. The core CPI rate is running at around 1.5%. Headline inflation has fallen below 1% as a result of the sharp fall in oil prices and is likely to decline even further.

Wage inflation also remains well contained, with growth in workers’ earnings running at around 2% year-on-year.

The US economy is expected to continue performing strongly. The IMF in its recent World Economic Outlook Update forecast US GDP growth of 3.6% in 2015 and 3.3% in 2016. There are a number of factors which point to continuing strong growth.

US monetary policy remains highly supportive of growth, with the marked fall in long-term interest rates during 2014 representing a further loosening of monetary conditions. Meanwhile, the drag from fiscal consolidation has greatly diminished.

Strong growth in employment should continue to support consumer confidence and household spending. The sharp drop in energy prices will provide a further significant fillip to consumer spending. Notably, the Michigan consumer sentiment index has reached its highest level in 11 years. Meantime, the fall in energy prices also lowers productions costs, benefitting businesses and firms. The Federal Reserve has kept US interest rates pegged at virtually zero in spite of the strong performance of the economy. It indicated following a policy meeting last week it would continue to take a patient approach in deciding when to start increasing rates.

Financial markets believe the Fed will begin to hike US rates later this year, albeit at a very moderate pace. They are looking for Fed rates to rise to around 0.5% by end 2015 and 1.25% by end 2016 from 0.125% at present.

This represents a very slow pace of policy tightening. However, the markets believe the very subdued inflationary environment gives the Fed the scope to maintain a very accommodative monetary policy, even after it begins to hike rates.

Nonetheless, there is quite a gap between where the market expects rates to go to in the next couple of years and what the assessment of Fed officials is on the likely path of interest rates. At its December meeting, nine of the 17 Fed policy makers believed that rates would increase to between 1% and 2% by the end of this year. All bar two believed it would be appropriate for rates to rise to between 1.75% and 4% by end 2016. This is well above what has been priced in by markets.

Certainly if growth remains strong, the labour market tightens further and wage inflation starts to pick up, markets will have to reassess their very benign view of US interest rates.

Source: Irish Examiner February 3rd 2015

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