Fed up is a good thing for our export-led economy
Published 19/12/2015 | 02:30
On Wednesday night, the US Central Bank (the Federal Reserve) opted to raise its key benchmark interest rate from an historic low, the first such move since the onset of the financial crisis of 2007/8.
The quarter of one per cent (25bps) move in the Federal Reserve's base rate will result in slightly higher borrowing costs for US financial institutions, which will act as a constraint on activity and prevent improving economic conditions in the US from generating runaway inflation as the recovery progresses.
Though the move was widely expected in market circles, it was far from a foregone conclusion. For example, the Fed had previously stoked investor expectations of a rate rise in the run-up to its meeting in September. On that occasion it made no change.
This first hike in rates represents a watershed moment in the US and global economy, allowing the Fed to draw a line under the events of the financial crisis. In addition, it may also bring some much needed, and long awaited, certainty to a market which has been worried about the potential negative side-effects of raising rates after such a long time.
Initial market reaction suggests that the Fed's action is having the effect that was widely expected, namely a stronger currency with EUR/USD moving lower in the aftermath of the announcement.
Equities also rallied following the meeting, which will have pleased the Fed as it has promoted US growth over the past five years via the wealth effect of higher stocks.
Much of this reaction had already been anticipated by market participants in the lead up to Wednesday's meeting. As a result the dollar had already gained significantly against the currencies of most of its major trading partners over the course of this year. This has been particularly noticeable against the euro, where the divergent fortunes of the US and Eurozone economies have reinforced the effect, and resulted in the dollar strengthening 11pc against the euro year-to-date.
A similar theme has also played out in the sterling exchange rate against the euro, although to a lesser extent.
These moves in foreign exchange markets have fuelled Ireland's export-led recovery, and while there are also commensurate negative effects (such as imported goods and foreign holidays becoming more expensive for Irish consumers), there is no doubt that the beneficial side of the currency effect has been a key piece in the Irish recovery jigsaw.
With the first hike now out of the way, the attention of investors has now quite understandably turned to what happens next. Is this the first of many interest rate rises from the US? If so how many, and how fast will they come? Will the Bank of England follow suit, given the material improvements in the labour market there, and the seemingly ever-booming London property market?
Investors will keep a close eye on activity in emerging markets and China, as one of the key concerns about the Fed's actions is how it will impact economies which are heavily dependent on raising funding in US dollars, and now face more expensive debt servicing costs (as a result of higher rates, in conjunction with a stronger dollar). How emerging markets react decision will heavily influence the actions of the Fed over the next year as it is definitely not in the Fed's interest to catalyse a global downturn as a result of its actions.
In that regard, Fed Chair Janet Yellen's comments in the subsequent press conference garnered the most attention as she set out the Federal Reserve board's latest thinking on the trajectory of the US economy.
During both her prepared speech and the media questions, she attempted to soothe any rising concerns that the Fed would now embark on a pre-determined path to hastily move rates back towards historic levels. Instead she outlined clearly that the Fed will remain flexible in its approach and, above all else, will focus on the story that the incoming economic data is telling.
The fact that the US economy is now so strong enough for the Fed to contemplate rate rises is unambiguously a positive sign for the global outlook.
However, how Yellen navigates this uncharted territory over the coming months will be the key factor in whether this marks the beginning of a virtuous cycle of global economic growth, or merely a short-term blip of false hope before a return to a more pessimistic outlook.
Closer to home, looking at the implications for the Irish economy, there are two main factors. If this proves to be the signal that the global economy has finally emerged from the financial crisis with an associated pick-up in global trade, then that will be a positive for our export-led economy.
In a similar vein, with US interest rates likely to rise faster than those in the Eurozone, the dollar should be underpinned at the expense of the euro. This will be welcomed by Irish exporters.
John Moclair is Head of Retail Treasury Sales & Customer Group Operations at Bank of Ireland.