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US can expect higher interest rates than widely predicted

05 Sep 2016

The US is likely to see higher interest rates over the next 18 months than expected by the market, despite ongoing global economic and political uncertainty.

Employment and inflation levels in the world’s largest economy will provide the Federal Reserve room to tighten monetary policy in the next 18 months without hindering an economic recovery, says Macquarie Securities North America economist David Doyle.

Doyle expects the central bank to lift the fed funds rate three times by the end of 2017, with the first increase tipped for December to 1.13 per cent, from 0.25-0.50 per cent now. The futures market is significantly less sanguine, pricing in a rate of 0.65 per cent by the end of next year.

Doyle says market fears that global political risks will impact financial markets and growth, prolonging the accommodative policy in the US, may prove unwarranted in the face of the ongoing American expansion. Economic data - in sectors ranging from manufacturing, retail and home sales - have pointed to a recovery.   

 “There is a widespread perception that we are in a stagnation or deflationary period,” says Doyle. “In coming months, consensus will shift towards recognising that inflation is coming back; but that it is a healthy, benign inflation that is positive for risk-taking.”

Rate probabilities

The Federal Open Market Committee surprised markets last September when it held rates at record lows amid market turmoil, but went on to lift borrowing costs in December.

The Committee, which hasn’t moved rates since then, in late July forecast stronger economic activity and employment.

The aftermath of UK’s Brexit vote on June 23 saw expectations of any further rate rises in 2016 dissipate, however a rebound in equity markets has since seen that recover.

The implied market probability of a hike by the end of December 2016 is now 50 per cent, well below Macquarie’s 80 per cent probability forecast.

Employment, prices

Doyle says the US economy is on solid footing with both employment and prices.

The US jobless rate has fallen to 4.9 per cent from nearly 10 per cent in 2010, and the nation has created an average of 189,000 jobs a month in the past six months. Prices will be further underpinned by the rebound in oil and the stabilisation in the dollar, which has stopped a decline in the value of imports.

Doyle references two data sets that show stronger trends than more widely followed readings. 

The first is the Atlanta Fed’s Wage Growth Tracker, which computes the evolution of all individual salaries, and has climbed to a seven year high of 3.6 per cent.
That compares to the 2.5 per cent wage-growth reading from the Bureau of Labour Statistics (BLS).

Doyle also points to the Federal Reserve Bank of Cleveland’s Median Consumer Price Index (CPI), which has climbed to a multi-year high of 2.6 per cent, compared with the official headline CPI of 0.8 per cent from the BLS.

Year ahead

The Federal Reserve will only raise rates gradually and cautiously, providing support for financial markets worldwide, says Doyle.

“The Federal Reserve is very comfortable in allowing the economy to run a little bit hot for a period of time,’’ Doyle says. ``It’s a goldilocks for markets. Investors will appreciate a central bank that’s normalising policy gradually, together with an economy that’s doing quite well.”

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