The Federal Reserve (Fed) hiked rates by 0.25 per cent in December 2015 and promised to continue raising rates at a ‘gradual’ pace. Its dot chart, which it uses to convey expectations about the future path of interest rates, showed an average of four rate hikes for 2016.
However, things don’t seem to be going according to the initial plan. So far this year, Fed members have backpedalled from earlier signals, as US equity markets have tanked, and high-yield bond spreads spiked. This change in Fed sentiment was also evident in the statement from the January Fed meeting.
Rates may stay low for some time
At the February congressional testimony, Fed Chair Janet Yellen said she had been surprised by the abrupt drop in oil prices and the sharp tightening in financial conditions, even though the US economy remained healthy.
The Fed would need to re-assess the outlook, a hint that the Fed could keep rates on hold at its March meeting. Yellen remained confident that headwinds would fade and predicted that inflation would ultimately return to 2 per cent, implying the rate-hiking cycle would resume later.
Why the Fed is unlikely to raise rates
We, however, do not think the Fed will hike rates this year. In fact, rates may stay low for some time. The December 2015 rate hike may end up being a ‘one and done’ hike. The Fed has shown a great sensitivity to market movements in recent months and market ups-and-downs could remain centre-stage.
Global monetary policy divergence may be another hindrance. The more the Fed waits, the greater the risk the US economy starts slowing as cyclical headwinds peter out. The US economic cycle is now in a more fragile phase as much of the post-crisis catch-up has been done.
Car sales and construction are two sectors to monitor
The sharp drop in oil prices is likely to profoundly affect US oil production – which has so far remained resilient – and has the potential to shock the US economy. In addition, the recent tightening in financial conditions may hit the ‘real economy’ with a lag. The recovery has been underpinned by household and corporate debt in recent years, its Achilles’ heel. Car sales and construction are two sectors to monitor.
Core inflation may stay subdued, especially if inflation expectations continue to slide. Core Personal Consumption Expenditures (PCE) inflation has been below 2 per cent since April 2012; it has averaged 1.5 per cent since 2009, and we think it will remain low.
US economy is expected to slow
If the US economy and the job market decelerate, which we expect by the second half of the year, the Fed may well cut rates. After a likely cut, we expect the Fed’s interest rate on excess reserves to stay at 0.25 per cent throughout 2017. The Fed is unlikely to reduce its balance sheet for some time. The fed funds future market is currently expecting the fed funds rate to be only around 0.6 per cent by December 2017.
Policy makers’ room for manoeuvre to prevent a recession is increasingly slim
The prospect of low-for-longer US rates raises questions about the Fed’s preparedness for the next downturn. Yellen said that negative rates could be used, as the option of more quantitative easing seems to have fallen out of fashion among Fed members.
Negative rates have become the theme du jour among market participants. The current debate about negative rates also exposes a wider problem: that US policy makers’ room for manoeuvre to prevent a recession is increasingly slim. This underlying fragility could remain a background concern for market participants.