Business World

Tuesday 25 October 2016

Why the coming US interest rate hike is like none ever witnessed before

Peter Spence

Published 14/12/2015 | 08:33

The headquarters of the US Federal Reserve in Washington
The headquarters of the US Federal Reserve in Washington

It is hard to overstate the significance of the decision that Janet Yellen, the US Federal Reserve chairman, and the rest of the Federal Open Market Committee (FOMC) will take later this week.

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America’s central bank is expected to start raising interest rates, in the first such move since the summer of 2006. The anticipated economic shift has been described as “momentous” and a hugely significant milestone of progress in the repairing of the US economy since the damage done by the Great Recession.

But for many City and financial services workers, it will mark an altogether new experience. Many now working on Wall Street were not even around for the last so-called “hiking cycle”. It is estimated that around a third of traders have seen nothing but near-zero interest rates during their careers. A large chunk were teenagers when the Fed last raised its rates.

It has been a long wait for those in the industry who are veterans of a previous rise. The US central bank, often considered the world’s most influential, has held rates at their emergency lows of 0pc to 0.25pc since late 2008.

In doing so, it has steered the economy according to its dual mandate, to promote job growth and steer inflation towards its 2pc target. Policymakers have said for some time that the jobs side of that mandate has been fulfilled. The FOMC has delayed only because it has wanted more evidence that US inflation will return to target before increasing its rates.

Fed officials have described themselves as “data dependent”, waiting for official statistics to show that the runway is clear before attempting lift-off. A string of positive surprises in the latter half of this year appear to have made an exit possible. Growth appears entrenched, and climbing retail sales indicate that consumers are more confident.

Market data reveals that investors are all but convinced that the Fed is now ready to act, believing there is a 74pc chance that policymakers will raise rates on Wednesday. Yellen’s recent comments have implied that it would require a significant shock to derail plans for higher rates.

Earlier this month, she said the US had “recovered substantially since the Great Recession”, with growth “sufficient enough” to continue putting Americans in work and push inflation back to the Fed’s target.

However, the rate rise now being considered by the FOMC will be very different from its previous one, when it moved rates up from 5pc to 5.25pc nearly a decade ago. This time around, the world’s most powerful central bank will be raising rates from historically low levels, in a world much changed by the introduction of large-scale quantitative easing packages and layers of financial regulation.

When the Fed does finally pull the trigger on its first rate rise since the crisis, there are fears over just what the effects will be. Many are worried that the Fed’s main weapon has lost its accuracy, or could misfire altogether. The largest change since the crisis has been the growth of vast amounts of excess reserves – the amount of cash sloshing around banks – which has ballooned from a measly $2bn before the crisis, to some $2.6 trillion today. Fed economists have described the current levels as “superabundant”.

All of this may throw “a wrench in the works”, according to Andrew Wittkop, a portfolio manager at bond trading behemoth Pimco. In the past, bond yields have tracked the Fed’s main interest rate, and in turn been able to guide all interest rates in the economy. “This link may now be broken,” Wittkop says.

The challenging task of steering interest rates upward will fall to an Englishman. Simon Potter, of the Federal Reserve Bank of New York, is running the operation, and has overseen its design.

He has admitted that the floor they will attempt to put underneath market interest rates is “soft”, and the central bank could lose control on occasion. As such, interest rates in the wider economy might not always move up, as the FOMC desires.

The Fed is unlikely to lose control entirely, but how the process will unfold in these uncertain waters is an unknown. Several analysts have warned that the period following the first rate rise could be “turbulent”.

What might be more challenging still is convincing investors that the path of increases after the first increase will be “gradual”. This word has become key to the Fed’s vocabulary, intended to reassure markets that its approach to further rate rises will be slow and steady. Too fast, and it is feared that the Fed could choke off not just the US economy, but also send shock waves through emerging markets, which are dependent on the US for growth. Signs that higher US rates were approaching threw currencies of these vulnerable economies into turmoil this summer.

With a move by the Fed seeming all but certain, it is hard to tell how markets could react. In the vernacular of financial markets, the rate rise has largely been “priced in”. Which is why the Fed’s comments on the timing of future rate rises will be key.

International observers, such as the International Monetary Fund, have urged the Fed to take it slow, lest it risks another downturn. Yellen’s next task is to convince everyone else that the Fed can keep its word.

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