Oliver Mangan Chief Economist at AIB discusses the US Federal Reserve monetary policy meeting in our latest economics blog.

US Federal Reserve remains cautious on interest rate hikes

US Federal Reserve remains cautious on interest rate hikes

As expected, this month’s monetary policy meeting of the US Federal Reserve saw it maintain the key funds interest rate at 0.375% for a second consecutive meeting writes Oliver Mangan Chief Economist at AIB

The decision to leave policy unchanged, though, was not unanimous, with one of the 10 voting committee members preferring to raise interest rates. The tone of the post-meeting statement showed that the Fed remains positive on the prospects for the US economy, but, at the same time, it is cognisant of the risks emanating from the global economy and financial markets. The statement describes the economy as “expanding at a moderate pace despite the economic and financial developments of recent months”.

 

The Fed noted that a range of indicators point to a further strengthening of the labour market. It remains of the view that the economy should continue to expand at a “moderate pace” and that labour market indicators will continue to improve. However, it stated that “economic and financial developments continue to pose risks”.

 

In her post-meeting press conference, Fed chairwoman Janet Yellen struck a fairly cautious tone. While noting that core inflation has picked up recently, she said, “it remains to be seen if this firming will be sustained”. She also commented that economic growth abroad appears to be running at a somewhat softer pace than previously expected.

 

Ms Yellen also emphasised that by proceeding cautiously in the rate-tightening cycle, it will allow the Fed time to verify that the labour market is continuing to strengthen despite the risks from abroad. She also once again repeated the line that the Fed expects economic conditions will “warrant only gradual increases” in interest rates. This more cautious approach to hiking interest rates is reflected in the Fed committee members’ latest projections on the likely path of interest rates.

 

These indicate that only two rate increases are likely this year compared to the four hikes contained in their last set of projections made in December. This would see the Fed funds rate rise to 0.875% by year end. Despite the rowing back on its expectations for the future path of rate increases, the Fed is still indicating a slightly more aggressive trajectory of rate hikes in 2016 than the market is expecting. Current futures pricing suggests that the market is looking for only one 25bps rate rise late this year, taking the Fed funds rate to 0.625% by end-2016.

 

Of course, the extent of any Fed tightening will depend on how the US economy performs, including the labour market and the path of inflation. The Fed has also indicated that it will be paying close attention to developments abroad and on financial markets and the risks these could present to the economic outlook.

 

The Fed still sees rates rising to 3% by 2018. Market expectations are that US rates will rise to just 1.25% by end-2018 so there is quite a large gap between the market and the Fed on the likely path of interest rates over the next couple of years. This may be due to the fact that while domestic economic conditions may point to the likelihood of a series of rate increases, the market’s view is that there could well be ongoing constraints on the ability of the Fed to tighten policy, as has proved to be the case over the past year.

 

The unemployment rate in the US has dropped to an eight-year low of 4.9% while job growth has been particularly strong over the past six months. Meanwhile, inflation, excluding energy prices, has been moving higher. Economic growth is expected to be sustained at a reasonably good pace. Yet the Fed is very reluctant to raise rates. There has been only one rate increase so far in this cycle, which was in December. It means official interest rates in the US are still close to zero at just 0.375%.

 

The Fed has been indicating for some time that rates will eventually have to rise to well above this level. However, to date, it has avoided doing much about it. It will come as a big shock to markets if the Fed changes tack and actually raises rates gradually but steadily over the next couple of years. It remains to be seen if this firming will be sustained.

 

 

Source: Irish Examiner March 29th 2016

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