The Fed Awakens (Finally!)

The Federal Reserve raises US interest rate

Yesterday (16.12.15) the Federal Reserve, as had been widely anticipated, finally raised US interest rates (strictly the target rate for Fed Funds) by 0.25%; so the target which had been 0 to 0.25% is now 0.25% to 0.5%. As we have indicated in the past this of itself is likely to have little impact (and indeed brings the rate only up towards what UK base rates have been for the last seven years). Nonetheless market commentators duly went into overdrive – and perhaps unsurprisingly with it being the first time since 2006 that the Fed has raised rates.

On message

What message do we take from the rate rise and associated press conference? First, the Fed believes the US economy is robust enough to withstand some small rise. The Fed ‘currently expects that, with gradual adjustments in the stance of monetary policy, economic activity will continue to expand at a moderate pace and labour market indicators will continue to strengthen.’ In particular, the Fed is a bit more relaxed about developments abroad (especially in China) than it was at its September meeting, although risks remain. US GDP is expected to grow by 2.1% this year and 2.4% next.

Not normal yet

Second, we are still some way off returning to normal conditions. Although the US economy is operating close to its potential, the Fed intends to maintain its accommodative monetary stance for some time. It will continue to reinvest the interest and principal payments from its holdings of bonds purchased under QE in further purchases. Future interest rate rises will be ‘gradual’ and not mechanical; ie. we should not necessarily expect to see a series of 0.25% rises every quarter. The median expectation of members of the Fed is for rates to be at circa 3.25% by the end of 2018, a level which is closer to the normal longer run rate. So no ‘normalisation’ any time soon.

The Fed still expects the effect of oil and commodity price falls on inflation to be transitory – but like many others it has been surprised by the persistence of weakness in energy prices. Janet Yellen did seem to indicate that she thought the floor was not that far away; and just from mathematics, prices don’t need to rise they just need to stop falling, for inflation to pick up again. Inflation is expected to rise to 2% (this is one of the objectives set the Fed) ‘over the medium term’.

The slow recovery

Why has US recovery from the financial crisis been relatively feeble? Janet Yellen usefully outlined some of the issues: ‘tighter underwriting standards and limited access to credit for some borrowers, deleveraging by many households to reduce debt burdens, contractionary fiscal policy, weak growth abroad coupled with a significant appreciation of the dollar, slower productivity and labour force growth, and elevated uncertainty about the economic outlook. Although the restraint imposed by many of these factors has declined noticeably over the past few years, some of these effects have remained significant. As these effects abate, the neutral federal funds rate should gradually move higher over time.’

Old age?

Ms Yellen was asked specifically whether, given the number of years that the recovery had already lasted, was there not a risk that the economy might roll over. Again, it is worth quoting her directly: ‘I feel confident about the fundamentals driving the US economy, the health of US households and domestic spending. There are pressures on some sectors of the economy particularly manufacturing and the energy sector reflecting global developments and developments in commodity markets and energy markets, but the underlying health of the US economy, I considered to be quite sound.’ Ms Yellen believes it is a myth that ‘that expansions die of old age.’ She also observed, however, what is clearly true, that there is always a possibility of some unknown risk or shock that could tip the economy into recession. She said that there was always a roughly 10% chance of a recession.

Not enough force

So where does this leave us? Well, the picture of a slowly recovering economy remains intact, and indeed has a bit more substance to it. This recovery, however, is not of a force to have much of an impact on oil and commodity prices and as we are seeing in the falling US market this evening, it is movements in these prices which are impacting share prices in the short term. It is to be hoped that Janet is right that we are close to a floor in oil and commodities. Over the longer term continued strength in the US economy should be good for equities.

Have a very Happy Christmas and may the Force be both strong and with you!