The process of interest rate normalisation continues apace in the United States. On Wednesday night the US Federal Reserve Bank increased interest rates by 0.25%, taking the target range for the key Federal Funds Rate to 1.75% to 2%. This rate has been taken up from zero in December 2015.
The Federal Reserve move this week came as no surprise but the forward guidance issued by the interest rate setting body, the Federal Open Market Committee (FOMC,) was perhaps slightly more aggressive than might have been expected. It is important to remember that the mandate of the central bank is to foster maximum employment and price stability. Price stability is defined as a rate of around 2%.
In the statement accompanying the latest rate move, the FOMC justified the latest increase on the basis that the labour market has continued to strengthen and economic activity has been rising at a solid rate. Indeed, in May the unemployment rate fell to 3.8% of the labour force and the economy created a strong 218,000 jobs during the month. The Committee also pointed out that recent data suggest that household spending is strengthening and business fixed investment has continued to grow strongly. At the same time inflation on key measures has moved close to 2%.
The Federal Reserve is achieving its mandate and indicated this week that it expects to deliver further gradual increases in its key interest rates over the coming months. It is certainly possible that another 1% will be added to rates over the coming year.
This interest rate trend is purely and simply a move away from an emergency interest rate situation that was put in place to deal with an exceptional economic crisis and now that crisis has abated and gone away, we are moving back towards a more normal interest rate environment.
The markets are continuing to take the normalisation on interest rates in their stride. The 10-year bond yield is currently trading at 2.96%, which is pretty much where it has been trading in recent months. One would expect bond yields to gradually rise from here over the coming months. On the equity market front, US markets barely reacted to the latest interest rate increase and in the year to date, the Dow Jones is up by 1.95% and the S&P 500 is up by 3.82%. While these gains may look modest, it does represent a very impressive performance in the context of the various challengesencountered by markets in recent months. The large tech stocks are the key drivers of the strong equity market performance, which does represent a reason for some caution.
In Europe, the situation stands out in contrast to the US. The process of interest rate normalisation has not yet started and the European Central Bank (ECB) is not in any hurry to do so.
The ECB has an official inflation target of 2% or slightly lower. The inflation rate has been consistently well below 2% for a prolonged period of time, but in May jumped to 1.9% from 1.2% in April. On the surface this does look worrying, but the surge is largely due to energy costs. In the year to May, energy costs increased by 6.1%, reflecting what is happening crude oil prices. Brent Crude is currently trading at $76.36, which is the highest level seen since late 2014. At one level this increase in oil prices would be seen to damage economic growth in the Euro Zone, but from the perspective of central bankers, the fear is that higher oil prices would start to feed into wage pressures as workers seek to offset the negative impact of oil prices on their cost of living. The ECB will watch these second-round impacts of higher oil prices very carefully over the coming months.
The growth backdrop in the Euro Zone has undoubtedly softened so far in 2019. In the first three months of the year, GDP expanded by just 0.4% during the quarter and the annual rate softened to 2.5% from 2.8% the previous quarter. This is still a decent level of growth, but most economic indicators are suggesting a modest softening in growth. The recent strength of the euro will help allay any nervousness the ECB might be feeling at the moment.
This week the ECB left its key interest rate unchanged at zero and it remains relatively relaxed. However, it did suggest that the monthly bond buying programme (Quantitative Easing) will remain at its monthly rate of €30 billion until the end of September, and this will then be reduced to €15 billion per month and will then end. In relation to official interest rates, the ECB currently believes that rates will remain at current levels at least through to Summer 2019.
This prognosis is all predicated on growth continuing at current levels and inflation gradually converging towards 2%. Of course, circumstances can change, but for the moment the ECB is quite relaxed about the world it governs.
Tracker mortgage holders and other Irish borrowers can remain relaxed for the moment but should also recognise that this nirvana will eventually end. The question is when? The answer is not yet.
The views and opinions expressed in this article are those of the author.
Originally published on www.friendsfirst.ie June 2018