Thursday, December 15, 2016

Fed Rates Rise - In depth: US interest rates

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.
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.

Source Financial Times

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