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US rate hikes approaching
For the first time in six years the US Federal Reserve could raise its key interest rates in 2015. In her testimony before Congress on 24-25 February, Janet Yellen laid out the conditions that would be required for the US central bank to raise rates. What are the key factors that could lead to such a rate hike? What would the impacts be on the US economy and the rest of the world after a long period of historically low rates?
Sources: Macrobond, BGL BNP Paribas
The job market
The main argument in favour of a rate hike is that the US economy has continued to gain strength. This improvement is particularly apparent on the job market. Job creation has been steady for two years and recently exceeded a rate of 2% per year. During 2014, the US economy created around 2.5 million new jobs. The unemployment rate fell to 5.5% in February 2015 and is nearing the level below which the Fed estimates that wage pressures will mount and inflation will start to rise. The US central bank estimates the range for this critical threshold at between 5.2% and 5.5%. This is what economists call the non-accelerating inflation rate of unemployment (NAIRU).
Sources: Macrobond, BGL BNP Paribas
Purchasing power and inflation
This improvement in the job market, combined with the fall in the oil price, has contributed to a significant rise in the purchasing power of US households. Wages are increasing at an annual rate of about 2%. Business investment is also growing at a healthy pace. However, headline inflation has not yet begun to rise; on the contrary, it has continued to fall, mainly due to declining oil prices. But oil prices cannot account for the entire drop as core inflation, which excludes food and energy prices, also hit new lows. The Federal Reserve's preferred measure of core inflation thus stood at a rate of 1.3% per year in January. This decline in core inflation can be attributed in part to the rise in the dollar which results in a lower import bill.
Monetary policy reaction
Beyond these short-term impacts, the job market recovery suggests that upward pressure on inflation is likely to materialise in the medium term. As such, the timing of the first interest rate hike is an important decision for the Federal Reserve. If it acts too soon, it runs the risk of choking off the recovery and prolonging a potentially highly detrimental disinflationary trend. If it waits too long, it could end up having difficulties in managing the rise in inflation when it does materialise. It also runs the risk of contributing to potential bubbles in other investment categories. Against this backdrop, Janet Yellen specified that the Federal Reserve will wait for clearer signs that inflation is returning to levels closer to 2% before it starts raising rates. This suggests that the most likely timing of the first rate hike is September 2015. Developments at the macroeconomic level could, however, push this target date forward or back.
Impacts on the rest of the world
Once the US interest rate hiking cycle begins, the effects will be felt around the world. First in the US, where, all else being equal, rate hikes should contribute to a growth slowdown in 2016 relative to 2015, which is off to a very good start. The effects will also be felt in emerging countries, where many governments and corporations have dollar debt. The challenges will be particularly great for countries in this group that are major commodity exporters. They face a significant drop in the price of these commodities in recent months. Lastly the effects will be felt in Europe, where long-term rates should to some extent follow in the footsteps of rising US long-term rates. European long-term rates could therefore also start to rise, but in all likelihood at a more gradual pace.
BGL BNP Paribas
6 March 2015 - Published in the Luxemburger Wort (in French)