Fed Not Likely to Increase US Rates Until September

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The US economy slowed sharply in the first quarter of the year, with annualised GDP growth falling to just 0.2% from 2.2% in the final quarter of 2014, writesOliver Mangan Chief Economist at AIB.

Thus, the economy virtually stagnated in quarter one.

This was largely the result of a number of temporary factors, such as severe weather conditions in parts of the US and a west coast port strike. Lower investment by energy firms, as a result of the collapse in oil prices, also negatively impacted on GDP.

The breakdown of quarter one GDP showed personal consumption remained the main driver of growth, contributing 1.3 percentage points. However, business investment was weak, deducting 0.4 percentage points from GDP.

Meanwhile, net exports also acted as a drag on growth, depressing GDP by 1.3 percentage points. This may reflect the combined impact of port strikes and the firmer dollar. A sharp fall in exports accounted for 1 percentage point of the overall drag from trade.

Despite the slowdown in growth, the labour market remained generally strong in quarter one. While non-farm payroll growth did slow to 126,000 in March, this came after 12 consecutive months of 200,000 plus gains, during which time the unemployment rate fell from 6.7% to 5.5%, a seven-year low.

Meanwhile, wage growth is starting to pick up. The wages and salaries component of the Employment Cost Index recorded growth of 0.7% in quarter one, resulting in year-on-year growth of 2.6%, up from 1.8% a year earlier.

On the inflation front, though, the sharp decline in oil prices has seen the annual CPI inflation rate fall sharply to -0.1% by March. However, the core CPI rate (excluding-food & energy) remains stable at around 1.8%.

The expectation is that, as in 2014, the US economy will recover from its quarter one setback and grow strongly over the remainder of the year. There are a number of factors underpinning this expectation.

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 diminished. Solid growth in employment and rising wages should support consumer confidence and household spending. Lower energy prices are also providing a further fillip to consumer spending.

The Federal Reserve’s most recent economic projections, which took account of the slowdown in quarter one, showed GDP growth of around 2.5% being pencilled in for both this year and next year. Thus, the recovery in activity is expected to be sustained.

However, the recent weakness in US economic data, combined with a more cautious tone in Fed statements and speeches, have resulted in a significant scaling back of rate hike expectations by financial markets.

The first full 25bps increase in US rates is not now expected until late 2015. By contrast, at the start of the year, close to three full 25bps rate hikes were being in priced by markets for this year.

We expect Fed rate hikes will materialise later this year as lower energy prices, good employment, and wage growth support activity. The exact timing and extent of the rate tightening is data dependent and, therefore, the Fed will be paying close attention to the in-coming macro data.

In particular, the Fed will be looking for confirmation that the economy is regaining momentum, as the headwinds evident in the first quarter abate. However, a rate hike at the next Federal Reserve meeting in June seems rather unlikely, given the recent weakening in activity and current very low inflation rate.

Thus, the Fed may wait until its September meeting before starting to hike interest rates. By that stage, it should have a clearer picture of the trajectory of the economy. If the economy does indeed regain momentum, markets may have scaled back too much on their rate hike expectations for 2015.