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Rate rise: the Fed awakens

Rate rise: the Fed awakens

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The US Fed has raised rates for the first time since June 2006. But was it needed? Rupert Seggins & Marcus Wright look at the following key aspects of the US economy: inflation, the labour market, growth & the global backdrop to establish whether a rate rise was necessary and some of the pros & cons of doing it now.

The US Fed has raised rates for the first time since June 2006. But was it needed? Rupert Seggins & Marcus Wright look at the following key aspects of the US economy: inflation, the labour market, growth & the global backdrop to establish whether a rate rise was necessary and some of the pros & cons of doing it now.

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Rate rise: the Fed awakens

  1. Rupert Seggins, Marcus Wright RBS Economics December 2015
  2. Inflation isn’t the phantom menace…it’s just a phantom 3 0% 1% 2% 3% 4% 5% Jan-05 Jan-08 Jan-11 Jan-14 Inflation expectations for 5-10 years' time Households Financial markets & finance professionals Source: Macrobond, Cleveland Fed • Inflation is well below the Fed’s 2% target. Headline inflation has been affected by gyrations in energy prices & dollar strength, but core has remained remarkably stable. • Expectations are well anchored. The Fed is not even close to a credibility problem. -2% 0% 2% 4% 6% 2005 2006 2008 2009 2011 2012 2014 PCE inflation (the Fed's favoured measure) Source: Macrobond Headline Core
  3. The labour market is pointing in 2 directions at once 4 • Employment has grown for an uninterrupted 5 years. Unemployment is at a level that the Fed thinks may spark future inflation. • But the share of people either in employment or looking for work is at its lowest since the late 1970s. • This cannot just be explained by shifting demographics & the financial crisis. 50 55 60 65 70 Jan-48 Jan-58 Jan-68 Jan-78 Jan-88 Jan-98 Jan-08 Participation rate - 16 & over (%) Source: Macrobond -600,000 -300,000 0 300,000 600,000 Feb-46 Feb-66 Feb-86 Feb-06 US non-farm payroll gains (12 monthaverage) Source: BLS, NBER *Shaded bars = periods of recession
  4. Wage growth….very far from alarming • Unit labour costs are rising, but growth in wages and salaries remains low. As in other developed economies, globalisation and technological change are holding back wage growth. • Demand-pull inflation doesn’t look like appearing anytime soon. -1.5% -1.0% -0.5% 0.0% 0.5% 1.0% 1.5% Average Hourly Earnings by Industry (% Y/Y Change, Differenceto 8-year Avg) Source: Macrobond - 1.0 2.0 3.0 4.0 5.0 -3 -1 1 3 5 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 2015 Unit Labour Costs and Wages (% Y/Y Change) UnitLabour Costs Wages& Salaries,RHS Source: Macrobond
  5. And growth isn’t shooting the lights out • Growth has been ticking along nicely compared to recent years. But it’s modest compared to the pre- crisis period. • Personal consumption growth is robust, but it’s cooled a little in recent months. 0.0 1.0 2.0 3.0 4.0 1995-2007 2003-2007 2012-2015 2015 USGDP Growth (Annualised Rate, Y/Y Change) GDP Personal Spending Source: Macrobond -4% -2% 0% 2% 4% 6% 2005 2007 2009 2011 2013 2015 US - PersonalConsumption (% Y/Y Change, 3mma) Personal Consumption (Exc.Food & Energy) Source: Macrobond
  6. Investment is….meh! • Fixed investment is a similar story to spending – solid but not spectacular. • Investment in intellectual property (around 25% of private fixed investment) has remained robust while commodity related investment has fallen. • Durable goods orders – a leading indicator of investment – are falling. • And so has manufacturing capacity utilisation. -40% -30% -20% -10% 0% 10% 20% 30% 40% 1995-2007 2003-2007 2012-2014 2015 US Private Fixed Investment (% Y/Y Growth) Mining& OilfieldMachinery Intellectual Property Total Private FixedInv Source: Macrobond 65 70 75 80 85 -40 -30 -20 -10 0 10 20 30 2005 2007 2009 2011 2013 2015 Durable Goods Orders and Capacity Utilisation Durable Goods Orders, Y/Y Change, LHS Capacity Utilisation (%), RHSSource: Macrobond
  7. The global backdrop is hardly great • The last time the Fed raised rates, China and the Eurozone were growing twice as fast as they are now. And exports were consequently booming. • But now, global growth is stuck in the slow lane and exports are falling in volume terms. -2% 0% 2% 4% 6% 8% 10% Past 20 years 2004-2007 2012-2015 Past Six Months US Exports and World Trade (Volume, % Y/Y Change) US Export Volume World Trade Source: CPB -5 0 5 10 15 US Export Growth (Volume) China Growth EZ Growth Global Growth %Y/YChange US Rate Rise - The Global Backdrop Q2 2006 (Last FedRate Rise) 2015 Source: IMF, Macrobond, Bloomberg
  8. China slowing and other EM concerns • China is slowing more than the headline figures suggest. • Its problems are structural not cyclical so the slowdown likely has a lot further left to run. • Emerging market firms have been increasing their leverage. A significant proportion of that is dollar- denominated. Higher US interest rates potentially spells further trouble. 0 5 10 15 20 1998 2000 2002 2004 2006 2008 2010 2012 2014 EstimatingChina's 'True' Growth ReportedGDP GDP'Estimate' Source: Bloomberg,Macrobond, RBSEconomics 1.0 1.5 2.0 2.5 3.0 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 Leverage Ratio of Corporations (Annualised Ratio) Emerging Economies Advanced Economies Source: BIS
  9. Easy does it 10 •At the very least the Fed's tightening cycle is going to be extremely gentle when compared to the past. And it won't take much at all for tightening to become easing once again. 0% 1% 2% 3% 4% 5% 0 10 20 30 40 Cumulativepercentagepointincrease Months following 1st rate rise decision Mar-83 Jan-87 Mar-88 Feb-94 Jun-99 Jun-04 OIS forward curve implied Source: Macrobond
  10. Trying to create some wriggle room 11 •The Fed may be looking to create room to respond to future slowdowns in growth. Especially given that it feels the unemployment rate is sufficiently low that higher inflation could be around the corner. 0% 5% 10% 15% 20% 25% Feb-71 Feb-81 Feb-91 Feb-01 Feb-11 Recessions Federal Funds Target Rate -5.00% -5.50% -5.25% Source: Macrobond
  11. -10 -5 0 5 10 Debt Service Ratios - Change since 2008, Private Non-Fin Sector Source: BIS Watch out Emerging Markets! •The Fed has spent much of the year preparing the ground for a rate rise, aiming not to repeat 2013's taper tantrum. But, it will have to continue communicating its intent to gradually raise interest rates. • Otherwise an abrupt tightening of global financial conditions could occur, an unwanted outcome given concerns over the debt loads in emerging markets. Mainly Developed Economies Mainly Emerging Economies
  12. Final thoughts • The US is better placed than other major developed economies for a rate hike. But it’s not clear that one is needed. •The risk is that the Fed treads the well-worn path of other central banks in places such as the Euro Area, Sweden & Switzerland. Rates rise, disinflationary forces intensify and rates have to be brought down further than before. •There is an argument in favour of higher rates to cool asset price growth and risk-taking. But interest rates are a blunt tool for this purpose.
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  14. 15 Disclaimer This material is published by The Royal Bank of Scotland plc (“RBS”), for information purposes only and should not be regarded as providing any specific advice. Recipients should make their own independent evaluation of this information and no action should be taken, solely relying on it. This material should not be reproduced or disclosed without our consent. It is not intended for distribution in any jurisdiction in which this would be prohibited. Whilst this information is believed to be reliable, it has not been independently verified by RBS and RBS makes no representation or warranty (express or implied) of any kind, as regards the accuracy or completeness of this information, nor does it accept any responsibility or liability for any loss or damage arising in any way from any use made of or reliance placed on, this information. Unless otherwise stated, any views, forecasts, or estimates are solely those of RBS’s RBS Economics Department, as of this date and are subject to change without notice. The classification of this document is PUBLIC. The Royal Bank of Scotland plc. Registered in Scotland No. 90312. Registered Office: 36 St Andrew Square, Edinburgh EH2 2YB. The Royal Bank of Scotland plc is authorised by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and the Prudential Regulation Authority. © Copyright 2015 The Royal Bank of Scotland Group plc. All rights reserved

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