US interest rates break 17-year drought: CommSec

Joel RobinsonMarch 21, 20180 min read

As widely expected, the Fed increased the target range for the federal funds rate by 0.25 per cent to 1.50-1.75 per cent. This was the sixth increase in interest rates of the current monetary policy tightening cycle.  The decision by the Fed voters was a unanimous 8-0.

US interest rates higher than the Aussie cash rate: The federal funds target rate is higher than the Reserve Bank’s official cash rate of 1.50 per cent for the first time in over 17 years. 

US interest rate outlook: The Fed is forecasting two further rate increases in 2018 and three further hikes in 2019. The 2020 projection is for two interest rate hikes. 

US economic outlook revised higher: Economic growth (GDP) forecasts were increased to 2.7 per cent in 2018, up from the previous forecast of 2.5 per cent. The 2019 forecast was moved higher to 2.4 per cent, up from 2.1 per cent previously. Growth is projected to decelerate to 2.0 per cent by 2020.

US at full employment: The unemployment rate is expected to fall to 3.8 per cent in 2018, down from 3.9 per cent in 2018. The unemployment rate is expected to fall further to 3.6 per cent in 2019-2020.

Inflation to reach target in 2019: Inflation is expected to remain below the Fed's 2 per cent target this year at 1.9 per cent. But the Fed expects the core Personal Consumption Expenditures (PCE) deflator (inflation) to increase to 2.1 per cent, above previous projections for 2.0 per cent in 2019 and 2020. 

Changes in US monetary policy settings can affect rates in Australia as well as the sharemarket and currency.

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What happened and what does it all mean?

The US central bank, the US Federal Reserve, increased the target range for the federal funds rate by 0.25 percentage points to 1.50-1.75 per cent, as expected. More interest rate increases are forecast due to the improving economic outlook. 

The US unemployment rate is at a 17-year low. Now US interest rates have increased above Aussie interest rates for the first time in over 17 years.

The last time the US federal funds target rate was above the Reserve Bank’s official cash rate was December 2000. US interest rates were higher than Aussie cash rates for the period July 1997 – December 2000. How the world has changed since then. 

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Back in those days the cash rate in both countries was well above 6 per cent and the Aussie dollar slumped to just US48 cents in early 2001.

Fast forward to 2018 and the Aussie economic expansion is now into a record 27th year, while the slow-but-steady increase in US output is into its ninth year. Should the US expand for another year, it will exceed the 10-year economic boom of the 1990s – the last time US interest rates were higher than their Aussie counterparts.

US Federal Reserve decision

Today’s decision by the US Federal Reserve was well telegraphed and uniformly expected by financial markets. The gradual tightening of monetary policy and removal of stimulus continues in the new Jerome Powell era. 

It was just three weeks ago that influential Federal Reserve Board Governor Lael Brainard spoke at Harvard University and opined: “Mounting tailwinds at a time of full employment and above-trend growth tip the balance of considerations. With greater confidence in achieving the inflation target, continued gradual increases in the federal funds rate are likely to be appropriate.” 

Since then the US labour market has continued to strengthen. Consumer sentiment has hit new post-Global Financial Crisis highs and core inflation, while still below the Fed’s 2 per cent target, has lifted sequentially. The Fed’s preferred measure – core PCE inflation – is now a quarter percentage point higher in annualised terms than its low in mid-2017.

Retail sales and housing data has been weak at the beginning of 2018, but the US Federal Reserve has decided to look through this data and potentially a weaker March quarter economic growth print.

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In terms of the Federal Open Market Committee’s (FOMC) press release, the FOMC reiterated that future interest rate adjustments will be data dependent and that “economic conditions will evolve in a manner that will warrant gradual increases in the federal fund rate”. The FOMC acknowledged that the “economic outlook has strengthened in recent months.” Inflation is expected“to move up in the coming months”. And “job gains have been strong in recent months, and the unemployment rate has stayed low”. Though household spending and business investment “have moderated” from late last year.  

The median path for the fed funds rate was changed in 2019-2020. The FOMC’s Summary of Economic Projections shows the median interest rate projections (the “dot plot”) still implies two further 0.25 per cent interest rate increases in 2018 (to 2.125 per cent); three 0.25 per cent interest rate increases in 2019 (to 2.875 per cent); and two 0.25 per cent interest rate increases in 2020 (to 3.375 per cent).

The policy-relevant core PCE deflator inflation projection were little changed. Core PCE inflation is still expected to run at 1.9 per cent in 2018. The FOMC lifted its core PCE forecast by 0.1 per cent to 2.1 per cent in 2019 and 2020.

The FOMC upgraded its GDP forecasts and lowered its unemployment rate projections. The FOMC projects GDP growth of 2.7 per cent in 2018 (previously 2.5 per cent) and 2.4 per cent in 2019 (previously 2.1 per cent). Meanwhile, the FOMC expects the unemployment rate to be 3.8 per cent in 2018 (previously 3.9 per cent) and 3.6 per cent in both 2019 (previously 3.9 per cent) and 2020 (previously 4.0 per cent).

The Fed continues to unwind its huge balance sheet. Holdings have declined to around US$4.4 trillion, the lowest since September 2014. The Fed plans to shrink the balance sheet by US$10 billion per month then accelerate the pace of reduction every three months. Eventually, holdings will be reduced by around US$50 billion per month until a “new normal” balance sheet holding is achieved. Fed Chair Jerome Powell has estimated that the balance sheet could drop to US$2.4-US$2.9 trillion after several years of cuts. 

US sharemarkets reacted positively initially to the well telegraphed outcome - especially given a fourth rate hike was not added in 2018 - with the Dow Jones Industrial Index briefly trading higher 250 points. However, shares declined into the US market close on weaker sentiment. Investors would be comforted that the FOMC largely left its interest rate outlook unchanged and US economic projections are stronger. US 10-year Treasury yields rose to 2.91 per cent before rallying back to 2.88 per cent. The US dollar fell and the Aussie dollar rallied from overnight lows near US76.70 cents and was near US77.66 cents in late US trade.

What are the implications for interest rates and investors?

The US economy is in rude health. We expect growth to remain above potential at around 2.8 per cent this year – the fastest pace of growth following the Global Financial Crisis.

Despite recent sharemarket volatility, financial conditions are still very accommodative and supportive for growth. The University of Michigan current economic conditions index for March was at record high (since 1978).

The Trump Administration’s fiscal expansion will likely lend support to late cycle US economic growth. The ‘leg-up’ from US$1.5 trillion worth of corporate tax cuts and additional government spending of around US$10 billion per year on infrastructure is expected to add around 0.5 percentage points to growth in 2018. Robust business investment and consumer spending, and a soft US dollar are additional growth sources. 

One of the challenges for Fed policy makers this year is to determine the full impact of the Trump tax-cut plans. The recent fiscal stimulus has probably not been fully baked into economic forecasts. And with US output and the labour market at near full capacity, concerns are building about an overheating economy.  

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The Fed will also be contending with a deteriorating US budget deficit and government debt situation. The US posted its largest budget deficit in six years in February at US$215 billion. And the deficit for the fiscal year that began in October 2017 widened to US$391 billion compared with a US$351 billion shortfall the same period a year earlier. The US gross government debt load has breached US$21 trillion or 106 per cent of GDP.

US President Trump’s tax policy is expected to reduce US federal revenue by more than US$1 trillion over the next decade, while a US$300 billion spending deal reached by the US Congress in February could push the deficit higher. So the corporate tax cuts will be funded by an increase in the US budget deficit, resulting in an increase in the issuance of US Treasury bonds. 

And the Fed’s interest rate hikes will likely expand the budget deficit even further by raising the Trump Administration’s cost of issuance, thereby further increasing the supply of US Treasuries. Rising supply, especially shorter dated bills, is already weighing on fixed income markets. And around US$425 billion of bonds will be maturing this year with the Fed only reinvesting US$195 billion of this amount. Who will pick up the shortfall?

If the Fed meets market pricing expectations for potential interest rate hikes, it will probably succeed in flattening the yield curve further – especially with the term premium curve flat already – then more likely we’ll see further episodic market volatility. 

With inflation running below 2 per cent, doubts over the Fed’s forward guidance will persist. However, base effects from wireless phone services’ price discounting, potential US dollar depreciation, tighter labour markets and a closing output gap should push annual inflation higher from mid-2018. 

Overall, we see the US economy growing above potential, supported by fiscal stimulus, still-low inflation and synchronised global growth. US President Trump’s policies, especially around trade, are the major ‘wildcards’. However, Fed Chair Jerome Powell said that US trade policy should not affect the economic outlook.    

CommSec expects two further US interest rate hikes in June and September this year.

Ryan Felsman is a senior economist at CommSec.

Joel Robinson

Joel Robinson is a property journalist based in Sydney. Joel has been writing about the residential real estate market for the last five years, specializing in market trends and the economics and finance behind buying and selling real estate.
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