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The timing of tightening

The timing of tightening

Rate rise later rather than sooner as Yellen stays cautious

by Bronwyn Curtis

Mon 16 Mar 2015

For the US Federal Reserve, getting into quantitative easing was easier than getting out. Market participants, highly focused on the timing of the first interest rate rise since the financial crisis, may be forgetting the complexities of policy tightening after QE.

If the US economy accelerates, there is a chance that the Fed will be behind the curve in its tightening action. But my feeling is that the Federal Open Market Committee at its meeting on 17-18 March will err on the side of caution. The FOMC might prefer to risk suffering an inflation surge from a very low level, rather than stalling the economy right now. It is therefore reasonable to expect a rate increase later rather than sooner – in the second half of the year or even in 2016.

The US economy has moved up a gear, but it has been a long wait. This cyclical recovery has been the opposite of other post-war cycles. Instead of a sharp acceleration followed by a flattening off, we had the long flat growth period first. Now it is starting to accelerate with consumer spending set to record the strongest growth since the expansion began.

It isn’t all good news. Businesses are reluctant to make long-term investments, suggesting they are still not confident about the future. Wage growth remains at the relatively low 2% average of the past four years, with no sign of acceleration.

If this were a ‘normal’ upward cycle we would have wages pushing higher by now. Vacancies are as high as the peak of previous cycles and the unemployment rate is down to 5.5% - around the level that the FOMC has indicated in the past that it would expect the previous slack in the economy to be used up.

The dollar has risen another 9% on a trade-weighted basis since the beginning of 2015, damping both inflation and growth. However, the US is a relatively closed economy with consumers accounting for 70% of GDP while exports make up just 13%.

The inflation picture is critical for policy and inflation rates will be trending lower for another three months with consumer prices set to turn negative. It is hard to see how the majority of the Fed voting members would feel ‘reasonably confident’ by June that inflation was moving back up towards 2% over the medium term unless there are some significant upward surprises to both wages and inflation between now and then.

Last year was already a good period for the US if you compare it with the 10-year average for the main US indicators. At 2.2%, growth in 2014 was better than the 1.7% 10-year average. Unemployment, the current account deficit and inflation were all lower than the 10-year average. Now the fall in the oil price has given extra impetus for 2015.

So I expect GDP growth this year and next will be close to 3%. Consumer confidence has been rising and so has employment. Non-farm payrolls have posted average gains of 293,000 per month for the last six months.

Real consumer incomes are being boosted by the fall in energy prices with US consumers projected to save around $100bn on fuel this year. If they spent it all, that would boost GDP by 0.5%. Fed Chairman Janet Yellen knows all this – but my instinct is that she will hold back from endangering the recovery by a premature easing.

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