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US tightening will be shallow

US tightening will be shallow

The Fed may raise rates just once in 2016 – and then cut again

by Thomas Costerg

Tue 8 Dec 2015

The US Federal Reserve is likely to raise interest rates for the first time in nine years at its next monetary decision-making meeting on 15-16 December, but next year’s tightening cycle is likely to be shallow. By December 2016 the Fed may have to start cutting rates again as the economic cycle weakens.

US rates have been near zero since December 2008. In view of expectations that a rate hike is close, the focus of financial markets has shifted towards predicting subsequent increases. The December 2016 fed funds future is around 0.83%, implying fewer than three hikes next year. In fact, the pace of tightening is likely to be lower than this.

After the December rise, the Fed is likely to make just one interest rate increase next year – in March. By June, uneven US growth and still-low inflation could persuade the Fed to pause tightening, with a cut possible at the end of 2016. The Fed is likely to continue to reinvest in government bonds and mortgage-backed securities, as its stock of debt acquired in previous bouts of quantitative easing matures. This should continue at least until 2018.

Previous Fed tightening cycles are unlikely to be a reliable guide to next steps. In 2004-06, the Federal Open Market Committee tightened rates by 0.25 percentage points at each meeting from June 2004. The pattern continued with the transition in chairmanship from Alan Greenspan to Ben Bernanke in early 2006 until August 2006, when tightening stopped with the fed funds rate at 5.25%.

One key difference this time is that the dollar has appreciated sharply before the tightening cycle, up 19% on a trade-weighted basis since mid-2014. Additionally, the Fed is starting to hike rates as the US economic cycle is showing signs of maturity; in 2004, the economic cycle was in full swing. Furthermore, inflation is structurally soft, partly due to global factors.

A maturing economic cycle combined with tighter financial conditions is likely to lower growth in 2016 compared with 2015. Data indicate the cycle may be past its peak. Corporate profits were down 4.7% year-on-year in the third quarter, according to the US bureau of economic analysis. Payroll growth has slowed this year. Business inventories are high. Household credit is picking up sharply, consistent with a late-cycle stage.

Factors that have boosted growth so far look set to peter out next year. Automobile sales, sensitive to higher interest rates, could plateau next year. The consumption fillip from lower gasoline prices is mostly past. The US energy ecosystem, which has been strongly influenced by the sharp rise in shale production in recent years, will continue to struggle. US oil production is likely to fall sharply next year, in a delayed reaction to falling oil prices. This will depress growth in Texas, the main engine of US expansion in recent years.

The Fed could upset this prediction and raise rates more rapidly if inflation quickens, particularly as measured by core personal consumption inflation, but this is unlikely. The biggest inflation risk comes from health-care services, but price rises here have been surprisingly low. With plenty of rental construction coming onto the market next year, rent growth – an important factor in core inflation – may start to fade, keeping core inflation in check.

The dollar should continue to strengthen in the near term, and the currency’s strength will continue to lower import prices. Later in 2016, as uncertainty about the first rate hike dissipates and the market anticipates shallow tightening, the dollar is likely to lose support. Selected emerging market currencies should perform better. Combined with expected macroeconomic stabilisation in China, this should help support flows into emerging market local currency debt during 2016.

Thomas Costerg is a New York-based senior economist at Standard Chartered Bank.

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