The Federal Reserve, the U.S. central bank, changes its mind when the facts change. In 2016, it’s going to do that again – by not raising interest rates four times during the year, like it recently said it would.
When the Federal Reserve – which is meeting today – met in December, it raised the Fed funds interest rate (which is the interest rate the central bank charges to lend money to other U.S. banks) for the first time since June 2006. Although the increase was small – just 0.25%, or 25 basis points – it was the Fed’s way of saying that the U.S. economy was healthy enough to leave intensive care.
At the time, the Fed indicated that it believed interest rates would be raised four times during 2016, to a range of 1.25%-1.50%. This would mean that many central banks around the world would also raise interest rates, leading to higher lending rates for borrowers (and higher returns on cash for depositors). But just one month into the new year, there are a lot of reasons why the Fed won’t raise interest rates four times this year.
The Fed lifts or cuts interest rates to meet two key domestic objectives (known as its “statutory mandate”). One aim is full employment (the current U.S. unemployment rate of 5.5% is within the Fed’s desired range). The other objective is price stability, which means making sure inflation (which is another way of referring to how much prices change) isn’t too high or too low. The Fed aims for a 2% annualised rate of inflation.
Higher interest rates tend to reduce inflation. That’s because people have more of an incentive to save at higher rates (since they’re earning more interest on their cash) than to spend money. They are also less likely to borrow money to spend, since the interest rate on the cash they borrow is higher.
While inflation in the U.S. has been slowly rising over the last few months, it’s nowhere near the mandated target of 2%, as the figure above shows. Worse still, expectations of future inflation fell during 2015. The five-year, five-year forward inflation expectation rate, which measures what investors expect inflation to be over the five years that begin five years from now (that is, 2021 – 2026) is at the lowest level since the global economic crisis. (This is calculated from the differences in yields for forward contracts of U.S. government debt and inflation-protected U.S. government debt).
Even though this is a long time into the future, it shows that investors are losing confidence that a 2% inflation target will be achieved. This reduces the chances of the Fed raising interest rates.
Also, beyond the U.S., many of the world’s biggest economies, including the Eurozone, Japan and the EU, are experiencing inflation near 0%. Often, as we recently explained, central banks follow the Fed’s lead. But with so many economies on the verge of deflation (falling prices), their central banks will have to maintain current very low rates, or even cut their rates. The Federal Reserve is unlikely to aggressively raise interest rates in the U.S. if other big economies are moving in the opposite direction.
The Fed has in the past shown that it takes circumstances in non-U.S. markets into consideration (as it should). In September, U.S. interest rates were not raised – as was widely expected – in part because of economic turmoil in China. (It’s easy to blame a lot on China – but this was actually the case last September).
It’s likely that China’s economic growth will continue to slow. The International Monetary Fund (IMF) predicts that China’s economic growth will fall in 2016 to 6.3% (from 6.9% in 2015) and in 2017 to 6.0%. This, along with the depreciation of China’s currency, which is a big concern to investors and could cause a lot of economic disruption, makes it less likely that the Fed will want to raise rates.
Finally, higher interest rates support a stronger U.S. dollar. The trade-weighted dollar index, measuring the U.S. dollar’s value against 26 world currencies (including 11 Asian currencies), is now at its highest level since 2002. When a country raises its interest rates, its currency becomes more attractive, in part because investors can earn more on their cash there than elsewhere.
This strength hurts U.S. exports, which become more expensive in foreign currencies. This could over time hurt U.S. economic growth. A strong U.S. dollar also hurts commodity prices, since most commodities are priced in U.S. dollars (which means they’re more expensive in local currency terms). With oil prices at near-13 year lows, a further series of rate increases will only add to the downward pressure on oil prices. This, in turn, will push down prices for a host of other things, and add to concerns about deflation.
The other side of a stronger U.S. dollar is weaker foreign currencies around the world. We recently highlighted how global currencies are hurt by U.S. rate increases, especially within ASEAN countries. Investors want to earn a higher rate of return on their cash, so funds leave these markets and head to the U.S. for higher rates. The Institute of International Finance estimates that a net US$500 billion left emerging markets in 2015, the first time since 1988 that more money left than was brought in.
Such volatility damages the ability of other countries to make good policy decisions. The Fed will take this into account…and decide that raising interest rates in the U.S. could do too much harm abroad.
So ignore the noise about the Fed raising interest rates. It won’t happen for a long while.