Rate Rise: The Fed Awakens

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Rupert Seggins, Marcus Wright RBS Economics December 2015 Rate Rise: The Fed Awakens

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But will the economy strike back? The US has raised rates for the first time since June 2006. But was it needed? We look at the following key aspects of the US economy: inflation, the labour market, growth & the global backdrop to establish whether a rate rise was necessary.

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Inflation isn’t the phantom menace…it’s just a phantom 3 Inflation is well below the Fed’s 2% target. Headline inflation has been affected by gyrations in energy prices & dollar strength, but core has remained remarkably stable. Expectations are well anchored. The Fed is not even close to a credibility problem.

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The labour market is pointing in 2 directions at once 4 Employment has grown for an uninterrupted 5 years. Unemployment is at a level that the Fed thinks may spark future inflation. But the share of people either in employment or looking for work is at its lowest since the late 1970s. This cannot just be explained by shifting demographics & the financial crisis. *Shaded bars = periods of recession

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Wage growth….very far from alarming Unit labour costs are rising, but growth in wages and salaries remains low. As in other developed economies, globalisation and technological change are holding back wage growth. Demand-pull inflation doesn’t look like appearing anytime soon.

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And growth isn’t shooting the lights out Growth has been ticking along nicely compared to recent years. But it’s modest compared to the pre-crisis period. Personal consumption growth is robust, but it’s cooled a little in recent months.

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Investment is….meh! Fixed investment is a similar story to spending – solid but not spectacular. Investment in intellectual property (around 25% of private fixed investment) has remained robust while commodity related investment has fallen. Durable goods orders – a leading indicator of investment – are falling. And so has manufacturing capacity utilisation.

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The global backdrop is hardly great The last time the Fed raised rates, China and the Eurozone were growing twice as fast as they are now. And exports were consequently booming. But now, global growth is stuck in the slow lane and exports are falling in volume terms.

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China slowing and other EM concerns China is slowing more than the headline figures suggest. Its problems are structural not cyclical so the slowdown likely has a lot further left to run. Emerging market firms have been increasing their leverage. A significant proportion of that is dollar-denominated. Higher US interest rates potentially spells further trouble.

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Easy does it 10 At the very least the Fed's tightening cycle is going to be extremely gentle when compared to the past. And it won't take much at all for tightening to become easing once again.

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Trying to create some wriggle room 11 The Fed may be looking to create room to respond to future slowdowns in growth. Especially given that it feels the unemployment rate is sufficiently low that higher inflation could be around the corner.

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Watch out Emerging Markets! The Fed has spent much of the year preparing the ground for a rate rise, aiming not to repeat 2013's taper tantrum. But, it will have to continue communicating its intent to gradually raise interest rates. Otherwise an abrupt tightening of global financial conditions could occur, an unwanted outcome given concerns over the debt loads in emerging markets. Mainly Developed Economies Mainly Emerging Economies

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Final thoughts The US is better placed than other major developed economies for a rate hike. But it’s not clear that one is needed. The risk is that the Fed treads the well-worn path of other central banks in places such as the Euro Area, Sweden & Switzerland. Rates rise, disinflationary forces intensify and rates have to be brought down further than before. There is an argument in favour of higher rates to cool asset price growth and risk-taking. But interest rates are a blunt tool for this purpose.

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