Why have rates in the US been held so
low for so long?
The US was hit by the
crash in its housing market and banking sector between 2007-09. The Fed felt it
needed to pull out all of the stops to prevent the economy from collapsing into
a new Great
Depression. One way of keeping things afloat was by cutting the cost
of borrowing to rock-bottom levels.
Will rates return to pre-crisis levels?
Not for the foreseeable future, according to Fed policymakers’
own projections. The Fed believes the rate compatible with stable growth and
prices has sunk sharply because of the lingering effects of the crisis and will
increase only gradually. In this subdued post-crisis world, the central bank
will need to keep its foot on the accelerator for some time to come.
How does a rise in central bank
interest rates get transmitted to the wider economy?
Adjusting the federal funds rate - the rate banks charge each
other for short-term loans - affects other short-term rates paid by firms and
households. These movements also have knock-on effects on long-term rates,
including mortgages and corporate bonds. Changes in long-term rates will have
an influence on asset prices, including the equity market. During the crisis
the Fed also purchased longer-term mortgage backed securities and Treasury
bonds to lower the level of long-term rates. These purchases could now make the
mechanics of raising rates more complicated for the Federal Reserve.
US ECONOMY
Is the US economy ready to cope with
more interest rate rises?
That is the trillion dollar question - and opinions vary widely.
To optimists, the Fed has managed to engineer a respectable recovery that is
outshining many other economies. They say a quarter-point increase, as the Fed
has announced, would have a negligible impact but is a sensible first step to
ensure the Fed stays ahead of inflation. Sceptics warn that inflation remains
on the floor and the Fed risks roiling world markets and pushing up the value
of the dollar.
Are businesses ready for increased
borrowing costs?
Many corporations have taken advantage of the low rate
environment to borrow money via the bond markets. Most companies say they are
relaxed about the impact of a small rate hike, believing the market has already
priced their bonds or such an event. However, some economists say the interest
payments for companies who have issued low-grade debt could rise more quickly.
What will higher interest rates mean
for consumers
An upward move in short-term interest rates will be positive for
savers who have been missing out on interest on their deposits. But the change
could also be transmitted to a range of other interest rates, including car
loans, credit cards and mortgages, which would make them more costly. However,
the burden of household debt has fallen since the crisis, reaching 114 per cent
of net disposable income last year, according to OECD statistics, suggesting
consumers are better prepared for higher borrowing costs.
Financial Markets
How are investors reacting to higher US
interest rates?
Investors' immediate reaction to the first rate rise in nearly a
decade was generally one of relief that it is finally happening. The end of the
Fed’s “zero interest rate policy” has been anxiously anticipated by investors
for more than a year, but policymakers have worked hard to stress that the
coming monetary tightening cycle will be exceptionally gentle, to avoid a
repeat of the market “taper tantrum” that erupted when they announced the end
of quantitative easing. From the intial market movements after the rate rise
decision was announced, it seems they have succeeded
How are currency traders positioning
themselves?
Currency markets are fickle, but differences in interest rates
tend to drive movements in the longer-run. For example, if a European investor
can borrow cheaply in Berlin and buy a higher-yielding US bond, then all else
being equal the dollar will rise versus the euro. As a result, the dollar
started the year in rip-roaring fashion, with an index measuring the US
currency against a basket of its peers rocketing to a 12-year high, as
investors bet on the Fed tightening monetary policy and bond yield differences
widened.
Since then it has continued to beat up emerging market
currencies but the broad rally has fizzled out as the euro and the Japanese yen
have regained their footing. However, many analysts and fund managers expect
the greenback to continue to climb higher in the coming years, as the Fed
raises interest rates further.
What investments are most sensitive to
interest rate rises?
Almost every asset class on the planet exhibits some evidence of
frothiness these days, but some seem more vulnerable to higher interest rates.
Normally, higher interest rates indicates that economic growth is firm, and
that is good for listed companies. Gold typically loses its shine when interest
rates climb, as the metal doesn’t pay any interest like a bank account will,
but has already been beaten up heavily recently. The bond market looks more
exposed. Highly rated debt is trading with very low yields, which means they
are vulnerable to even a modest rise in Fed interest rates, while bonds issued
by companies rated “junk” could suffer if more expensive borrowing tips some
weaker groups into bankruptcy.
Will the UK follow the US in raising rates?
There is no automatic or formal link
between US and UK interest rates but the widespread
expectation is that the Bank of England will be the next central bank after
the US to raise rates. The UK’s economic recovery is well on track, with solid
growth and a strong labour market.
The Bank
of England typically follows the Federal Reserve's lead
Historically, US and UK market interest rates, as measured by
government bond yields, have also moved in tandem. These are the rates, set by
the financial markets that feed down into the real costs of borrowing for
households and companies.
Bond
yields move in tandem
What are we expecting from UK
interest rate rises?
Bank of England
governor Mark Carney has stressed that while the next move in rates is likely
to be upwards, the path of increases will be “limited and gradual”.
In the most recent
meeting of the Bank of England's rate-setting monetary policy committee, all
nine members again voted to keep interest rates at historic lows of 0.5 per
cent. Most forecasters have now pushed back their estimates for when the BoE
will raise rates. JP Morgan believes a rate rise won't come until the first
quarter of 2017.
Global Reaction
Are all major central banks around the
world thinking of raising interest rates?
No. As the prolonged weakness in oil prices continues to keep
inflation low, many central banks in the rich world are expected to loosen
monetary policy further, for example by expanding their programmes of
quantitative easing. Mario Draghi, president of the European Central Bank,
paved the way for an extension of QE and the Bank of Japan cut its rates to
negative territory in January. In China, the central bank may also cut rates
further to stimulate growth. The outlook for emerging markets is harder to
gauge: were a Fed hike to trigger turmoil across Africa, Asia and Latin
America, countries there may choose to cut rates to help the economy, or
increase them in order to dissuade investors from taking their money abroad.
Why would a rate rise in the US impact
emerging market countries?
We have already seen one of the main impacts: a stronger US
dollar. Backed by higher US interest rates, the dollar tends to depress the
values of emerging market
currencies at a time when many EM economies are already
weakening and their currencies have already slumped against the greenback. The
Fed’s rate rise could exacerbate the EM currency turmoil, and even help
precipitate a full-blown crisis.
Jargon Buster
What is tightening and loosening?
When a central bank “loosens” or “eases” policy it essentially
increases the supply of money in the economy and pushes down the cost of
borrowing. This could be by lowering interest rates, or buying more assets with
the aim of putting more money into circulation and encouraging greater economic
activity.
“Tightening” is the opposite. If policymakers worry that an
economy is begin to overheat, potentially generating too much inflation, they
can tighten policy – such as raising the interest rate they charge banks to
borrow from them, to make the cost of credit more expensive.
Changes to interest rates can take up to 18 months to feed
through into the real economy.
What is monetary policy?
Central bankers control more than just interest rates. “Monetary
policy” is a broad brush term for a whole range of actions, including things
like selling or buying assets such as government bonds, raising or reducing the
amount of capital banks need to hold against liabilities, and raising or
lowering interest rates.
All of these actions impact the cost and supply of money in an
economy which are the main levers central banks use to try and keep inflation
at its target level and the economy growing at a sustainable speed.
Changes in monetary policy can take-up to 18 months to feed
through into the real economy.
Who makes the rate decisions within the
Federal Reserve?
The Federal Open Market Committee, sometimes called the FOMC.
This group of people are responsible for determining monetary policy, which
means they decide whether rates will go up or down. The FOMC has 12 voting
members: The seven people on the Fed's board of governors, plus five of the 12
regional reserve bank presidents, on a rotating basis.
Who are these FOMC members?
The Federal Open Market Committee within the
Federal Reserve has changed its look following it regular rotation of members
at the beginning of 2016.
Fed-watchers like to pigeonhole officials as hawks, who favour tighter policy,
or doves, who want
stimulus. Preferences on policy reflect many underlying issues,
however, and with the state of the economy in constant flux, it is never easy
to predict how a given official will vote. Janet Yellen, the Fed’s chair, for
example, is traditionally seen as a dove, but that did not stop her presiding
over the first rate
increase in nearly a decade in December 2015.
Issues that will matter in 2016 include the weight Fed officials place on
inflation versus unemployment; how far they think factors such as energy
prices, the dollar and slack in the labour market will hold back inflation;
their optimism about economic output; and the degree to which they worry about
financial stability.
Below is the Financial Times 2016 guide to the voting members of Fed’s FOMC,
how they think about monetary policy, and a tentative judgment on whether that
makes them a hawk, a dove, or somewhere in between.
THE DOVES
|
THE HAWKS
|
OTHERS
|
Source Financial Times
