After several months of hints, it was no surprise this morning when US Federal Reserve (Fed) Chair, Janet Yellen, announced another 25 basis point lift in the key Funds Rate. The hike, which is the second so far this year, brings the Funds Rate target range to 1-1.25% – still abnormally low compared to historical rates. Fed Board member published predictions show there is a high probability there will be one further 25 basis point hike this year and three more hikes next year, if inflation and unemployment continues to track along nicely.
Ms Yellen also stated that, for the first time since the Fed undertook massive bond-buying in markets, also known as quantitative easing (QE), it will shortly be gradually reducing the securities it holds on its balance sheet. This will begin the unwinding of one of the most dominant financial developments over the past decade, slowly normalising the financial environment.
Although Ms Yellen professed to be comfortable with the way the economy is developing, she may be a little nervous about recent inflation outcomes. Data on the May CPI, released the same day as her announcement, showed yet another slowdown in consumer price inflation. Core inflation, which strips out volatile energy and food prices, is running at an annual rate of 1.5% – well below the Fed’s desired rate. Money markets certainly showed they are wary, sending interest rates on longer-maturity bonds down sharply after the CPI release. Investors obviously now think that the Fed might have to go a bit slower on rate hikes than suggested in its latest statement.
Our view of the hike
In my view, the Fed will probably go ahead with another rate hike toward the end of this year. There are signs that the US economy is picking up a bit after a soft start to the year. Headline inflation is again being depressed by falling oil prices, but not to the same extent as a couple of years ago. Underlying inflation is also being dragged down by hot competition in retailing and services. However, businesses are generally expanding and hiring new workers and inflation-adjusted consumer spending is robust. Unemployment, at 4.3%, is so low that wages may soon start to accelerate from their current modest pace.
What it means for investors
However, despite a reasonable outlook for the US economy, anything more than moderate interest rate rises in the near-term is unlikely given the forces keeping a lid on inflation. For investors, this underscores the likelihood that future returns on bonds and shares will be more subdued than in the recent past.
The information provided, or any opinions expressed in this article, are of a general nature only and should not be construed, or relied on, as a recommendation to invest in a particular financial product or class of financial products. You should seek financial advice specific to your circumstances from an Authorised Financial Adviser before making any investment decisions.
John Carran, Senior Economist at Gareth Morgan Investments
You can read more articles by John on the GMI blog.