US Federal Reserve's continued rate hikes, what does that mean for Australia? Shane Oliver

EXPERT OBSERVER

 

As widely expected the US Federal Reserve raised the key Fed Funds rate by another 0.25% for the eighth time since starting to hike in December 2015. This takes the Fed Funds rate to a range of 2% to 2.25%.

 

Supporting this the Fed continues to see growth as “strong” and it revised slightly upwards its growth forecasts for this year and next and sees core inflation remaining around its 2% inflation target.

 

The median interest rate expectations of Fed officials (ie the so-called “dot plot”) was unchanged and continues to see four hikes this year and three hikes next year. See the next chart. However, more officials have moved into expecting higher rates and the longer run neutral rate moved up to 3% from 2.88%.

 

While the Fed is monitoring trade and emerging market risks there is no indication that either are about cause it to change its expectations for the US economy or slow down the pace of interest rate increases.

 

The only major change in the Fed’s post meeting statement was to remove a reference to describing monetary policy as “accommodative”. However, it would be wrong to read too much into this with Fed Chair Powell saying that the description’s “useful life was over”. And while the Fed may no longer be describing monetary policy as “accommodative” its very hard to describe it as tight either. The real Fed Funds rate has only just got back to being around zero and the nominal Fed Funds rate is still well below nominal economic growth. See the next chart. And both long term and short term yield curves are still positive and for what it’s worth the Fed Funds rate is still below the Fed’s estimate of the long term neutral rate which is around 3%. As can be seen in the next chart past US recessions were preceded by the Fed Funds rate being well above inflation and nominal growth and we are still a long way from that.

 

 

With the US economy remaining very strong and the labour market very tight it would be wrong to conclude that because the Fed is no longer describing monetary policy as “accommodative” that it will soon stop raising rates. The Fed continues to see further “gradual” rate hikes as appropriate and its own dot plot of interest rate expectations points to interest rates still having a lot more upside, to being eventually above the long run neutral level.

 

Our assessment remains that the Fed will hike again in December and like the Fed we expect three more hikes next year.  US money market expectations, which for example see just over two hikes over the next 12 months, remain too dovish (see the previous chart).

 

For Australia, the Fed’s latest hike confirms that US growth is strong and this is good for Australia. However, the RBA is a long way from following the Fed higher in terms of interest rates because there is still a lot more spare capacity in the Australian labour market compared to the US. See the next chart. We don’t expect the RBA to start raising rates until 2020 at the earliest.

 

 

Australian official interest rates have now fallen further below those in the US. And by the end of next year are likely to be over 1.5% below US interest rates. '

Historically, a low and falling interest rate differential relative to the US has seen the $A fall and so while heavy short positioning in the $A may see it bounce a bit higher in the short term, we ultimately expect further downside in the $A over the year ahead as US rates continue to rise further above Australian rates. However, strong commodity prices should prevent a fall to $US0.48 as occurred in 2001 which was the last time Australian rates were below US rates.