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Fed increases interest rate, a step up in normalization

The Fed’s decision to raise the target range of the Federal Funds rate by 25 bp to 0.5%-0.75% comes one year after it began normalisation at the end of 2015.

fed interest rateThe US Federal Reserve’s decision to increase interest rates heralds a more rapid normalisation of US monetary policy in 2017 and 2018, Fitch Ratings says. A changing macroeconomic and policy backdrop means that the Fed is less likely to delay further increases, although it will still move gradually by historical standards, and its monetary stance remains loose.

The Fed’s decision to raise the target range of the Federal Funds rate by 25 bp to 0.5%-0.75% comes one year after it began normalisation at the end of 2015. Fitche Ratings’analysts latest forecast is for two 25 bp hikes next year but there are risks of a faster pace of increase. US core inflation is now above 2% by some measures, wage inflation has picked up over the last 18 months, and unit labour cost growth has remained steadily above 2%. Unemployment is below most measures of the natural rate and this seems to be garnering greater attention in the Fed’s thinking.

Moreover, US growth is less likely to disappoint as it did in 1H16, thanks to a pick-up in private sector investment growth, tighter labour market conditions supporting consumption, and the short-term boost from the incoming Trump administration’s planned tax cuts.

The President-elect’s proposals are unlikely to be enacted in full, but Fitch assumed a fiscal stimulus of 0.5%-0.75% of GDP in our November Global Economic Outlook. This saw us revise our US real GDP growth forecasts to 2.2% in 2017 and 2.3% in 2018, up from our pre-election forecasts of 2.0% and 2.2%.

More expensive funding costs and a stronger dollar could counteract fiscal stimulus to some extent. The prospect of Fed hikes and reflationary US economic policy, combined with rising oil prices, have already pushed longer-term market rates sharply higher (10-year US treasury yields are around 2.5%, from around 1.8% in the run-up to the US election), but the still gradual Fed tightening that we forecast does not pose a risk to economic expansion. Policy rates are still low relative to growth and inflation prospects and sovereign borrowing costs remain low.

Possible triggers for faster Fed normalisation might include a bigger fiscal stimulus with a greater focus on public infrastructure than we currently anticipate and further accelerations in wage growth. In addition, the effect of fiscal stimulus on US inflation would be magnified if Trump were to follow through on promises to restrict imports from Mexico and China, but the timing and scope of any such measures are unpredictable and are not incorporated in our US GDP or interest rate forecasts.

The shifting US fiscal backdrop to the Fed decision illustrates how central banks will no longer constitute the only source of macro policy stimulus in 2017. Easier fiscal policy is one reason we expect global growth to pick up in 2017 (to 2.9%, from 2.5% this year).

But the interplay of US economic, fiscal and monetary policy may create global challenges. The prospect of US rate rises has led to periodic bouts of financial market volatility in recent years. With the ECB and BOJ still pursuing ultra-loose monetary policy, Fed normalisation is likely to extend the current period of dollar strength.

This could be positive for other advanced economies but may increase the cost or reduce the availability of external funding for some emerging markets. A stronger dollar and relative EM currency weakness are reasons why EM sovereign rating pressure looks likely to continue in 2017.

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