The Federal Open Market Committee (FOMC) is scheduled to meet on 27 and 28 Octoberto discuss interest rates, among other issues. At the time of writing, the federal fund futures trading pricesuggested a 6% chance for the Federal Reserve to raise the interest rate on federal funds by 25bps. That being said, we believe there are reasons to support the first rate hike since the global financial crisis.
In an interview with Bloomberg on 5 October, HKSAR Financial Secretary John Tsang said that the business community wanted more certainty from the U.S. Federal Reserve, as the timing of the first interest rate hike by the Fed disrupted market sentiment and business planning.
Since Janet Yellen took office in March 2013, the Fed has consistently referred to the U.S. inflation and employment situation as the basis for its interest rate decisions. Total payroll employment and unemployment rate are the go-to indicators in its discussions. As for inflation, the consumer price index (CPI) and the personal consumption expenditures (PCE) price index are the indicators to look at.
Using the PCE price index, inflation does exist and core inflation (i.e. excluding food and energy prices) went up 1.3%YoY in August. Nevertheless, dragged down by lower fuel prices and thus cheaper transportation costs, headline CPI has been modest since the beginning of 2015, averaging 0% during the first eight months of the year. The Fed expects inflationto rise gradually in the coming few years, but it will remain lower than the longer-run objective of 2% by the end of 2018.
Meanwhile, the labor market has improved notably. The unemployment rate fell from 10.6% in January 2010 to 5.1% in August 2015, while non-farm employment continued to expand at close to 2%YoY in September. The Fed expects such momentum to continue.
In IMF’s latest World Economic Outlook, the U.S. economy is projected to grow 2.6% and 2.8% for 2015 and 2016, respectively, while the output gap is expected to decline to -1.6% in 2015 and -1% in 2016. Such expectations signal the economy is on the right track of recovery. In our view, these trends are well supported by solid corporate profits (11.5% of GDP) and low delinquency rate (2.37%). Given the projected low inflationary environment, the Fed should raise the federal funds rate in the near future, but at a moderate pace of adjustments going forward.
Investors and businesses have been given two years to position their strategies since the launch of the tapering measures in October 2013. Perhaps, it is high time for a hikethis autumn.
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