Why the Fed is going to raise interest rates

Ignacio de la Torre. Professor. IE Business School

26 May 2016

The Brexit referendum blocked a rise in interest rates by the FED in June. But the arguments in favor of putting off said rise are fast disappearing, and economic realities all point to it happening in the near future.

There is a well known quote by Winston Churchill that goes: “the Americans can be counted on to do the right thing, after they’ve exhausted every other possibility,” which might explain why the US Federal Reserve, after experimenting with different monetary policies in the past, looks set to return to its origins and normalize interest rates by raising the cost of borrowing. 

We’ve recently seen a crucial discrepancy regarding estimates of the price of money in the United States: while the markets are betting on slow and steady interest rate increases, the Fed’s board members are predicting a sharp and aggressive hike between now and 2019. 

The implications either way are fundamental for the planet, given that the dollar is the de facto global reserve currency. Long-term rates in the United States are affected by short-term rates, and in turn, long-term rates in the rest of the world also tend to fall into line with those in the United States. It would seem, therefore, that if the Fed raises interest rates sooner and more sharply than the markets are predicting, then the price of money around the world will increase, which will affect businesses, governments, and people everywhere. 

In my opinion, the Fed will raise rates before the summer, and will do so in line with the prognosis of the members who decide monetary policy, which is to say two or three hikes this year and three or four in 2017, meaning the markets will be out of step. The reasons I believe the Fed will raise rates faster than thought are threefold: 

First: the Fed’s mandate is to keep prices rises to around 2 % a year and to maintain full employment. We’ll have a look at this second element below. Prices are showing an increasing tendency toward inflation. If we look at the component that the central bank assesses, underlying inflation, which excludes energy and non-processed foodstuffs, prices have already risen by 2.1% or 2.4 % this last six months. If we measure inflation in terms of personal consumption expenditures (PCE), which differs from the consumer price index (CPI) in that each product in people’s shopping basket is recalculated dynamically whereas the IPC goods are static and changed every 10 years, underlying inflation has been growing steadily to the current 1.6%, or 2.1% if the last quarter is annualized. Even if we bear in mind non-underlying inflation, the steady increase in oil prices has driven the CPI up to 1.1 %, a three-year high, and the most likely thing is that this increase will accelerate in the coming months as oil prices rise. Finally, housing has a big impact on calculating inflation, contributing around a third, and house prices, which are now rising at around 6% annually, suggest more inflationary pressure in the coming months.  

Secondly: Unemployment in the United States has fallen to around 5%. There is some discussion of how accurate this figure is, given that many people may well have given up hope of finding work and are no longer registered as unemployed, but the reality is that salaries are rising (2.4%), irrefutable proof that unemployment is falling. Other indicators are that unemployment among university graduates is around 2% the number of unfilled jobs, and that the number of unfilled jobs is around six million, the highest in the last 16 years. As a result of all this is that salaries are rising, and given that productivity has remained the same, the costs for companies are increasing, which in turn is passed on to the consumer. The Fed’s second objective is thus fulfilled; although it now brings with it a new threat to its first objective, stable prices. There is a huge inflationary risk and the Fed tends to bear in mind not just inflation but also the risk of inflation. 

Thirdly, the US economy is accelerating. After coming through a very weak first quarter of inter-annual growth of just 0.5%, the data for the second quarter are much more hopeful, reflecting the spring speed up we’ve seen in the last three years. The Fed’s real time growth forecasts show that the economy could be growing at 2.5%, which is to say five times faster than in the first quarter. The reason is more consumption via retail outlets and industrial output. 

Fourthly: the international context, seen by several Fed members as a reason for not increasing rates in the past, has changed considerably. During the first quarter, China was a serious concern for the global financial system, a concern that prompted serious weaknesses until February in the commodities markets, particularly oil, that affected many emerging economies, while in Europe the talk was mistakenly all about a new recession. To date, the Chinese economy is growing at 6.7% year-on-year, commodities have recovered to some extent, oil is at $50 a barrel, emerging currencies have gained and Europe’s economy has grown five times that of the United States’ in the first quarter. In my opinion, the emerging bonanza, including China, will not last long, but the Fed no longer has this excuse for holding back. 

Fifth: very low interest rates are an incentive to get into debt, and for assigning finance to projects that aren’t worth getting into debt for. This can plant the seeds of financial instability, which we saw between 2001 and 2007: controlled consumer inflation and uncontrolled asset inflation, the genesis of the credit crisis. The Fed’s mandate, decided on almost a century ago, includes a third mandate: financial stability, and today many economists are worried about rising instability. 

The conclusion to all this is that interest rate hikes are on the way and that they will happen more quickly than we have come to expect. The consequences will be potentially devastating for commodities, foreign exchange, the stock markets and emerging bonds, particularly for countries with a current account deficit. There will be greater volatility, long-term rates will suffer (a fixed-rate mortgage will be worth more in autumn), and the markets will be hit hard. 

I fear that we may see carnage in the markets this summer. 

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