The Fed has made it increasingly clear over the last month that it judges that a rate hike will be likely over the next few months if the world turns out how it expects it to. FOMC members seemed to be lining up one after the other to signal their support for a June or July move. The Chair of the Committee, Janet Yellen, rubber stamped these thoughts when she clarified that she also favoured a rate hike over the ‘coming months’. So there can be little doubt that a rate hike over the next few months is a possibility. This has severely challenged our view that the Fed will remain on hold this year, though the weak US payrolls data will now likely give the FOMC serious pause for thought. The big question is whether a Fed rate hike would be a good idea.
The Fed has made it increasingly clear over the last month that it judges that a rate hike will be likely over the next few months.
Nick Kounis Head of Macro Research
The Fed has been signalling that it will hike interest rates over the Summer months
The weak nonfarm payrolls could give the FOMC a reason to pause for thought, but a hike over the next few months is a possibility
A big question is whether it would be a good idea
Our view is that while there is a case for a hike, the case for the Fed to remain on hold and be more cautious is much more powerful
The case for a hike
The case for a further increase in interest rates goes something like this. US economic growth looks to be finally coming out of a soft patch, with early data suggesting GDP growth is accelerating. For instance, the Atlanta Fed’s now cast estimate stands at 2.5% for Q2 currently. In addition, the unemployment rate is historically relatively low at 4.7%, as it compares to pre-crisis trough of around 4.5%. The Fed’s other key objective – inflation – also seems to be going in the right direction. Core inflation on most measures is higher than it was say six months ago. At the same time, interest rates are historically low. The nominal fed funds rate stands at little less than 0.5%, while real interest rates are negative on most measures. It can be argued that historical low interest rates are not appropriate given that the Fed is not far from its main objectives. Some Fed officials make the case that such low interest rates in a benign macro environment risk stoking asset and credit market bubbles.
At the same time, the global environment looks to have stabilised compared to the start of the year. After the worst start to the year on equity markets since the Great Depression, risky assets have generally recovered. Although European and Japanese equities have not recovered their year-to-date losses, US and emerging market equities have. Indeed, emerging markets – a key source of vulnerability earlier in the year – look to be in better shape. Sharp capital outflows have been replaced by significant capital inflows. Commodity markets – led by oil – have recovered. Finally, China’s economic growth has regained some traction.
The case for caution
So a rate hike looks sensible right? Although most of the above points are fair, there are also strong arguments for caution. Indeed, on balance these look to be much more powerful in the current juncture.
To start with the US growth picture, to listen to some Fed officials, you would think that the economy was hot. However, the economic data is far from convincing. It is still a bit early in the quarter to know how Q2 economic growth will turn out. Much of the hard data relates only to April. What we do know is that the last two quarters have been pretty weak. GDP growth was just 0.8% qoq annualised in Q1, following 1.4% in Q4. Even a Q2 acceleration could leave the underlying trend looking rather lackluster. US business surveys are far from strong. The global economy also looks rather weak right now. The recently published global manufacturing PMI, shows the sector stuck at stagnation levels. World trade is even in slight contraction territory. Global growth should recover in the coming months given the easing in financial conditions and rise in oil prices (which should take the pressure off producers). However, the revival is likely to be moderate. For instance, despite recent signs of strength in China’s economic data, the authorities remain intent in keeping growth on a gradual slowdown trajectory, not least to ensure that credit growth and the property market do not once again overheat.
As for the Fed’s objectives, the story is not quite as clear cut as it may seem. For instance, despite low unemployment, wage inflation has been quite subdued, which may be a signal that the labour market is not yet at full employment levels. To put it another way, there is still slack that can facilitate the rise in employment without generating wage pressures. This means that the labour market has not been tightening recently. There is also a risk that companies will become more cautious in their hiring decisions going forward given moderate demand and weak profits. Profits have actually declined over the last year, though admittedly they may be exacerbated by the fall in oil prices and dollar strength. Those factors should ease going forward, however there seems to have been underlying weakness as well. Over the last two months employment growth has weakened considerably, which may be a sign that a slowdown in the labour market is materialising.
As for inflation, it has been rising but the measure targeted by the Fed is actually below its target. The core PCE price index was running at 1.6% yoy in April, whereas the stated goal is 2%. Of course monetary policy works with a lag. So if the Fed is confident that inflation will return to 2%, given economic developments, that should be sufficient. On the other hand, if inflation overshot the target after such a long period of undershooting (the last time it was at 2% was in April 2012) it would not be the end of the world. Indeed, it could even be argued that some overshoot would help to anchor inflation expectations by sending out a message that the Fed’s inflation target is symmetrical.
That leaves the issue of the financial markets. Market rate hike expectations have built over recent weeks. For instance, investors judged (before the weak payrolls) that there was more than a 50% probability of a July rate hike, whereas it stood at around 25% a month ago. Admittedly, this has not destabilised emerging market assets or broader investor risk appetite. However, over the last few years (starting with the taper tantrum in 2013) it has tended to. As noted above, fundamentals do look better now. Though it remains the case that many emerging markets that are a de-facto part of the dollar zone. Having built up high debt levels, they are therefore still vulnerable to a US-led tightening of financial conditions. The Fed must not only take actual conditions on financial markets into account when setting monetary policy, but also consider the effects their policies have on these conditions.
The overall verdict
Overall it seems that the potential adverse impact to the economy and markets of the Fed hiking are greater than the potential risks of waiting at this stage. This is especially the case given that the Fed has a lot of potential to tighten monetary policy in case it needs to, but more limited room to ease if things go wrong. Therefore a more cautious approach might be better for now. A modest rate hike might not be a disaster especially if the Fed signals that an additional step is a long way off, but why take the risk? In any case, a more significant series of rate hikes certainly would very likely create a significant headwind for the economy and markets.