Markets have reacted calmly to the Fed’s first hike in nearly nine years but uncertainties loom ahead.
On December 16th, the Federal Open Market Committee (FOMC) unanimously decided to raise interest rates for the first time in nearly a decade.
Over the last few months, markets have awaited the first rise nervously, but the short-term reaction was largely positive. The Dow Jones closed the day with gains, while an index that tracks fear in the bond market declined. Some emerging market indices also rose on the day.
The fact that emerging market stocks cheered the announcement is surprising, as these countries have been the main beneficiaries of accommodative U.S. monetary policy. Several years of quantitative easing and virtually zero rates have contributed to an influx of capital flows to these countries and a corporate debt build-up. Since higher rates would strengthen the U.S. dollar, this may lead to capital flowing out of these countries to the U.S. and make it difficult for companies in emerging markets to repay this debt.
Why did markets react positively?
Firstly, global markets were probably relieved that the uncertainty was over. A few months ago, several emerging market central bankers expressed the view that a hike was preferable to a delay.
Secondly, the rise is essentially a vote of confidence in the economy. Just as it is a good sign when a doctor decides a patient needs less medicine, the move away from zero rates effectively means that the Fed is confident about the recovery in the world’s largest economy. This is likely to be good news for the global economy, as the chart below seems to suggest.
Source: World Bank
Thirdly, markets may have applauded the Fed’s statement that future rate hikes are likely to be gradual.
This chart shows that most FOMC members expect interest rates to rise by only 1% this year and the next. The last round of increases occurred in 2004. The Fed raised interest rates by 1.25% in 2004 and by 2% in 2005. In 1994, rates rose even faster – the Fed funds rate doubled from 3% between January 1994 and February 1995, according to data from the New York Fed.
Source: Financial Times
The press release said that monetary policy would remain accommodative after this increase. Hence, the pace of rate hikes in this cycle is likely to be slower than in previous rate hike cycles.
How will the U.S. economy react?
The rate hike flowed through to some commercial banks on the very day of the announcement. Major U.S. commercial banks have also raised prime lending rates by 0.25% – the benchmark for most loans.
However, the effect of these increases on business investment and consumption cannot be determined yet. Moreover, the impact of this first rate hike on growth is likely to be negligible as rates are still extremely low by historical standards and are likely to remain so for some time.
The economy’s reaction will depend on the path of future rate hikes. Inflation is currently below the Fed’s 2% target but the press release stated that “The Committee judges that there has been considerable improvement in labor market conditions this year, and it is reasonably confident that inflation will rise, over the medium term, to its 2% objective”.
Some articles have stated that Fed has acted too early. Unemployment is lower than it was the last time the Fed started raising rates. In June 2004, the last time the Fed raised rates, unemployment was 5.6%. According to the most recent reading of November 2015, the rate is now 5%. This suggests that the FOMC has been cautious in raising rates this time. But there are risks to U.S. growth from the emerging market slowdown. Inflation may also continue to undershoot the Fed’s target if the decline in oil prices is sustained and the dollar appreciates.
Since 2008, the central banks in other developed economies that have raised rates have been forced to backtrack and cut rates. It is too early to determine if the Fed will also need to make a U-turn. This will depend on a number of global and domestic factors but gradual rate hikes will allow the Fed to monitor the effects of each hike on the economy and inflation, and respond appropriately. This slow pace may also prevent widespread volatility in global markets, although it remains to be seen whether the initial positive reaction will be sustained.
