Headwinds to a rate hike

Recent data from the U.S. Bureau of Labor Statistics is changing analysts’ estimates of when the Federal Reserve will start to hike interest rates.  

Admittedly, the February payrolls increase to 295,000 versus 235,000 is extremely encouraging, especially since employers have now produced 12 straight monthly job gains above 200,000. It’s the longest such stretch since 1994-95.

That, coupled with the drop in unemployment to a seven-year-low of 5.5 percent, is more than an encouraging sign as it puts the unemployment rate within the Fed’s target. Many analysts and investors think this will pave the way to the Federal Reserve raising interest rates.  

Taking a step back, the Federal Reserve has a dual mandate of price stability and full employment. Some analysts are suggesting the target for employment levels should have been dropped from 5.5 percent to 5.3 percent, which means job creation has a bit further to go.

Normally, 5.5 percent unemployment would be close to what the Fed would consider as full employment, but since the recession ended in June 2009, the percentage of adults working or looking for work has fallen to a 37-year low of 62.8 percent. It has hovered around the mark for most of the past year. The historically low participation rate is clouding the true labor situation.  

In regard to the second part of the dual mandate, price stability, Ben Bernanke the former Federal Reserve chairman, in prior years gave an inflation target of 2 percent. We are almost approaching 1.4 percent, which means that the economy still has a bit to go.  

Interest rates will most likely increase, and in a significant way, over the next few years or so, but the timing of a June rate hike is in question. After a typical recession, interest rates decrease to allow for cheaper lending to kick-start the economy.

In prior recessions, it took two to four years before investors started to see higher interest rates. This scenario is very different, as we have seen ultra-low rates for almost seven years.

That is an extremely long time for a central bank to retain essentially the same short-term lending rate. One would expect some sort of normalization of interest rates to occur by now, or at least in the near future.  

However, this time is different. The difference is the recession was massive and on a global scale. Most countries are still reeling from the collateral damage caused by the “debt crisis.” In order to get normalized growth, many countries are pursuing the same or similar monetary policy of quantitative easing as the U.S. to kick-start their economy to increase GDP growth and reduce employment.  

But these countries and economic zones are far behind the U.S. growth rate and unemployment rate, which will cause a headwind to curtail the U.S. increasing interest rates. For example, the unemployment rate in the 19 countries that share the euro is 11.2 percent, or twice the U.S. rate. This causes issues because it will put further pressure on exchange rates.

As it stands now, long-term interest rates are far above other developed countries and this is causing the U.S. dollar to significantly appreciate. As an example, the euro/dollar exchange rate has declined almost 20 percent from 1.35 to 1.08 over six months. In order for the U.S. to raise interest rates, it will most likely need to do so in conjunction or similar timing and amounts with other developed nations’ central banks.  

If the U.S. does increase interest rates, it will most likely attract much more investment capital seeking higher yields than intended. This has a knock-on effect of further decreasing exchange rates, which makes U.S. exports more expensive to foreign purchasers. Decreasing U.S. exports can curtail growth in the U.S. and have other unforeseen ramifications.  

Hence, it is anticipated that the Federal Reserve will begin the normalization process, but we may have a bit more time than many are suggesting due to the economic headwinds.  

 

Disclaimer: The views expressed are the opinions of the writer and while believed reliable, may differ from the views of Butterfield Bank (Cayman) Ltd. The bank accepts no liability for errors or actions taken on the basis of this information.  

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U.S. Federal Reserve Chariwoman Janet Yellen wants to wean investors from relying on central bank guidance on the future path of policy. – Photo: Bloomberg News
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