At their December 2015 meeting, the average view at the US Fed’s FOMC was that four rate hikes were likely in 2016. Financial markets did not like that message very much, leading to volatility and risk aversion and the effect on various economies was negative. We took the view that the Fed was unlikely to tighten policy further any time soon in such a vulnerable environment and that another hike would be unlikely before the end of the year.
The question this poses is whether or not the world economy and financial markets will cope better with this hike than with the previous one
Han de Jong Chief Economist
The Fed drew a similar conclusion soon after and were only counting on one hike this year from their March meeting on. One must clearly always keep an open mind and as Keynes is thought to have said: “when the facts change, I change my mind. What do you do, Sir?” Several reasons make me think that another US rate hike is coming closer.
- Another US rate hike is getting closer, whether it will be this year or next
- US tightening has led to increased volatility on financial markets in the past and to a negative response of the global economy
- The odds of a more positive development this time around have improved
Reasons to hike
First, as time passes and we are not changing our forecast about when the next rate hike occurs, it will, by definition, get closer. But I think there is more. Second, recent economic indicators have been relatively positive. The Fed obviously monitors the labour market closely and must have got somewhat concerned when employment growth disappointed during the March-May period when monthly employment gains were a mere 118,000 on average. Over 2015 as a whole, the average monthly gain was 228,000. But June and July of this year showed a significant improvement, averaging 274,000. Most other economic indicators confirm the picture that the economy is doing relatively well. And although economic growth is by no means spectacular and a material acceleration of inflation appears far away official interest rates look strangely low compared to the state of the economy at large. Hence, there is some need for higher rates.
Third, the international financial environment seems a lot calmer than during 2013 when the suggestion that the Fed might start tapering its asset purchases led to a wave of risk aversion and also calmer than shortly before (and after!) the December 2015 rate hike when EM (Emerging Market) currencies were under significant pressure. International capital flows out of EMs have also calmed. Take China. In the six months before the December rate hike, Chinese FX reserves fell by some USD 370 bn of which some USD 200 bn occurred in the last two months of the year. Chinese reserves have been very stable during the last couple of months, underscoring that things are currently relatively quiet in terms of net capital flows. This does not mean that renewed disruption, volatility and risk aversion could not happen again if and when the Fed raises rates, but the current situation looks much more stable than just before the December hike. The FOMC could therefore believe that it is now ‘safer’ to hike than it has been in the past.
Fourth, US LIBOR rates are creeping up. I am not enough of an expert on the US money market to have a good insight into what is exactly going on there. But the Fed could stop this creeping up if they wanted to. The graph above shows the 3-month dollar LIBOR rates. Note how the rate moved higher before the Fed’s hike mid-December last year, reflecting the market’s anticipation of the hike. At that time, the Fed did nothing to discourage market participants to think a hike was coming. The rate has again been creeping higher since early July and the Fed is, seemingly, not taking market action to stop or reverse it. This does not mean that they will tighten policy in September, but a September or December hike is becoming a possibility.
Reasons to wait
On the other hand, there are also reasons why the Fed should wait. Inflation is low and not accelerating in any serious was. Just released Producer Price data for July were surprisingly soft. Second, two good months of labour market data do perhaps not erase the doubts caused by three months of disappointments before that. Third, the recent Senior Loan Officers Opinion Survey shows that banks are tightening their lending criteria for corporates. The Fed may consider that it does not want to aggravate that process by raising interest rates at the same time. Last, the situation on international financial markets may seem calm, but why would the Fed risk triggering another upset now. For now, we still stick to our original view that the first hike will not occur until early 2017, but the chances of an earlier hike are increasing.
Could the rest of the world and financial markets cope?
The question this poses is whether or not the world economy and financial markets will cope better with this hike than with the previous one. The simple answer is that we cannot be sure, but there are a few reasons to take an optimistic view on this.
First, as indicated above, financial markets are calmer now than before the last Fed hike. Perhaps the perception is that the Fed’s tightening triggered stress and capital flows back in December, but the reality is that they were already in train when the Fed hiked. The Fed aggravated this development.
Second, the problem with higher US interest rates is that the long period of extremely low dollar interest rates since 2008 has led to the creation of a large amount of dollar debt outside the US. Asian companies in particular seem to have taken on a lot of dollar debt. What is worse, they had apparently not hedged their currency mismatch. When many currencies weakened against the US dollar temporarily in 2013 and subsequently from mid-2014 on and US official interest rates were raised last December, this led to big problems for companies with dollar debt and revenues in local currencies. Having experienced this problem both in 2013 and again around the December rate hike, one would hope and assume that these companies have cut their losses and have lowered their short dollar exposure, thereby reducing their vulnerability. What also helps this time around is that EM currencies have recently regained some ground, as compared to having lost a lot of ground prior to the December hike. Last, the bounce in commodity prices is positive for many EMs.
Third the global manufacturing cycle is about to gain some momentum, I think. Many EMs depend on that cycle and the stronger it is, the better they will be able to cope with higher US interest rates. Some evidence for my cautious optimism on the global manufacturing cycle comes from Taiwanese trade data. Taiwan’s exports are highly dependent on the global manufacturing cycle and having gone through a serious contraction, recent months have seen an improvement. The value of Taiwanese exports was up 1.2% yoy in July, the first positive reading since early 2015.