150813 us watch fed rate hike

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Group Economics

US Watch

Macro & Financial Markets Research Maritza Cabezas, +31 20 343 5618

Fed preparing for lift-off

13 August 2015 We expect the Fed to raise interest rates in September. GDP is growing above trend and we are seeing further improvement in the employment situation. In our view, the Fed will maintain a 25bp target range for the Fed funds rate, which implies that the first move will shift the target range to 25-50bp, ending at 50bp-75bp at the end of 2015 and 150bp-175bp at the end of 2016. All together this means one rate hike every other meeting in 2015 and 2016. The slow pace of rate hikes takes into consideration the somewhat tighter financial conditions, resulting from the strong dollar, given that the Fed is far ahead of other central banks. In line with this view our EUR/USD forecast for the end of 2015 remains 1.00. Introduction

Past and Present Tightening cycles in US economy %

Fed policymakers are giving signals that they are getting ready to hike rates this year. The US economy looks strong enough

8

to handle a rate hike. In this note we address how the Fed is

5.7

preparing for the rate hike, the path for interest rate normalisation and the instruments that the Fed could use in

5.4

4.2 4 2.3

2.2 1.3

this process. 0

Economy ready for a rate hike

GDP growth

unemployment

core PCE

This time around, the economy may not be as resilient but the 1 yr before

fundamental factors underlying US economic activity are solid

Now

and, in time, should lead to a pick-up in the pace of economic activity and inflation. Recently Fed policymakers have

Source: Thomson Reuters Datastream

mentioned that the economy would need to show “some” improvement before a rate hike. Since then statements from

Labour market conditions firm, wages subdued

Fed officials suggest that the economy is moving in the right

Unemployment has declined significantly during the recovery.

direction. For instance, Dennis Lockhart, President of the

Moreover, job openings and quits have been steadily

Federal Reserve Bank of Atlanta said in an interview with the

improving in the past year. However, wage growth remains

Wall Street Journal that a Fed rate hike is ‘close’, noting that

subdued. We think that slower productivity growth could be

he is open for a September move. Meanwhile, the President of

keeping wages supressed, since higher wages in a context of

the Fed St. Louis, James Bullard (voting in 2016) told the WSJ

lower productivity reduce profit margins. However, this should

late in July that “we are in good shape” for a rate hike in

not be an impediment to a rate hike. Fed Chair Yellen has

September. In this same line, President John Williams of the

repeatedly stated that higher wage growth is not a necessary

Federal Reserve Bank of San Francisco also reiterated his

condition for a rate hike.

forecast for a rate liftoff this year. In time, inflation should move towards the target GDP growth, lower but above trend

Inflation may look distant from the Fed’s 2% goal, but this is a

Long trend GDP growth has slipped somewhat since the global

medium-term objective. We expect that inflation will remain

financial crisis. Indeed, average trend growth was around

below 1% this year, but will move towards the 2% target next

3.1%, but the global financial crisis took its toll with a loss in

year. The strong economy should see slack dissipate, which

output and potential growth now around 2%. This suggests

should push up inflation. In addition, rising rent prices and the

that although US economic growth is lower than in previous

reduced pass-through from the stronger dollar should also lead

cycles, it is currently growing at above-trend rates. As a result,

to price increases in the coming months. Fed officials have

slack is diminishing and this is likely one of the major reasons

persistently signalled that they expect some of the factors that

the Fed will hike .

are exerting pressure on prices to wane.


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