What does it mean for investors?
The decision by the US Federal Reserve (“Fed”) to raise interest rates in December, finally brought to an end months of speculation. The move involved a 0.25% increase in the target range for the federal funds rate. This range is now 0.25-0.5%, which still leaves borrowing costs exceptionally low. However, this first US rate rise in nearly a decade probably marks the beginning of the end of near-zero borrowing costs, a legacy of the worst financial crisis to hit the world economy in modern times.
Markets responded positively, with investors perhaps expressing relief that the wait for the move was finally over. Fed chair Janet Yellen was careful to emphasise that further rate rises will only be implemented if the Fed thinks that the US economy is robust enough to take them and, even then, those rises are likely to be small and infrequent.
There is a suggestion within the Fed’s detailed forecasts that it could raise rates by another 1.0% in 2016. However, looking at US bond markets, current prices suggest that the general consensus among traders and investors is that the Fed will only implement two 0.25% increases during 2016. This combined uncertainty could cause volatility in financial markets.
Ms Yellen was keen to emphasise that the US economy had made “considerable progress” in recent years, and the economic projections released alongside the announcement maintained this positive tone.
She was also eager to highlight that inflation will play a critical role in the Fed’s rate decisions in 2016, alongside other important factors, such as unemployment and gross domestic product (GDP – the total value of all the finished goods and services produced in a country annually).
Current forecasts predict inflation will not return to the Fed’s target level of 2% until 2018. However, while the Fed’s remit is forward looking (since any changes in interest rates take a year or more to feed through to growth and future inflation rates), any disappointments in current inflation rates over the year ahead could stay the Fed’s hand.
Though the messaging of the December 2015 rate rise might have been clear, the announcements in line with expectations and financial markets satisfied, the Fed will still have its critics. On the one hand, there are those who worry that even this modest initial rate rise will prove too much for the US economy and will lead to a further extended period of slow growth and low inflation. Even if the US is robust enough to take it, there may be concerns about emerging market countries that have large amounts of dollar-denominated debt. The rate rise makes the US dollar stronger relative to other currencies and, therefore, more expensive for emerging markets to service their US dollar-denominated debt.
On the other hand, the Fed has also been criticised for leaving it too long to raise rates. Some are concerned that this will lead to a sudden increase in inflation, while others have pointed out that with rates still at such low levels, there is no room to cut rates in the future should another downturn take hold.
The well-trailed nature of the December increase and the emphasis on the gradual nature of any future moves provides comfort; the Fed’s priority is inevitably the domestic economy, but it is also sensitive both to global markets and the world economy. This increase does not, therefore, change our view that the global outlook for 2016 remains broadly on track and should involve a modest acceleration in economic activity accompanied by a gradual pick-up in inflation.
Forecasts of future performance are not a reliable guide to actual results in the future, neither is past performance a reliable guide to future performance. The value of investments, and the income from them, may fall as well as rise and cannot be guaranteed. Any views expressed are our in-house views at September 2016. Investment markets and conditions can change rapidly and the views expressed should not be taken as statements of fact nor relied upon when making investment decisions. This information may not be used, copied, quoted, circulated or otherwise disclosed (in whole or in part) without our prior written consent.
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