Over the last couple of years, the US Federal Reserve (Fed) has had the objective to raise interest rates to a more normal level. After signalling that US interest rates would rise in March, the Fed has stuck to its word by raising the base rate from 0.75% to 1%.
This is the second interest rate increase in 3 months and the third increase since the 2008 financial crisis. The objective is to head off higher inflation. For the 12 months to February 2017, inflation, as measured by the Consumer Price Index (CPI) rose 2.7%, which is above the Fed’s target of 2%. The Fed has indicated that there will be two further interest rate rises in 2017. The normalisation of interest rates may take a long time.
Mohamed El-Erian, the Chief Economic Adviser to Allianz and previously to President Obama, states that the Fed needs to strike a balance between two risks. The first risk is falling behind the curve, which could follow if President Trump manages to deliver quickly on his pro-growth and tax reform policies. The second risk is the premature tightening process, which could be caused by severe market instability, trade protectionism and/or the legacy of too many years of low and insufficiently inclusive growth.
The US economy is progressing, with the unemployment rate falling to 4.7% in February 2017 from 4.8% in the previous month. Industrial production has also risen 0.3% year-on-year in February of 2017, following a revised 0.2% gain in January.
One of the key questions in the UK is when will the Bank of England (BoE) follow the Fed’s lead and raise interest rates? The BoE Monetary Policy Committee last voted to retain interest rates at 0.25%, however, one member of the committee, Kristin Forbes, voted to raise interest rates. This was the first split between policymakers on rates, since July last year. Other members may join her at future meetings if they believe inflation is rising too quickly.
Inflation, as measured by CPI, over a 12-month period was 2.3% in February 2017, up from 1.8% in the month before. This is not only above the BoE’s 2% inflation target, but also at a 4 year high.
Official data has shown that UK pay growth, adjusted for inflation, has halved to just 0.7%. This is the lowest level since October 2014. Slower pay growth and rising inflation are dampening consumer spending. The ratings agency, S&P Global, has said that the UK is showing the first signs of waning economic growth.
Although wage growth remains a concern, the unemployment rate fell to 4.7% in the 3 months to January 2017, from 4.8% in the previous 3 months. This matches the rate last seen in 2005. It was last lower in the 3 months to August 1975, when it was 4.6%. Exporters are benefiting from the weak currency, with Morgan Stanley forecasting export growth strengthening to 3.1% in 2018.
The recent Budget had no real surprises, but in view of the uncertainty regarding Brexit, the Chancellor, Phillip Hammond, moved to bolster his ‘rainy day’ funds. However, there was a planned increase in National Insurance contributions for the self-employed, but a few days later, he retracted this increase for political reasons. There is now a large potential shortfall over the next year or two, which needs to be rectified.
Within Europe, 2017 is going to be a year of elections and a period of political risks. The first election held was in the Netherlands and the surprise was that there was no political shock, with the current Prime Minister, Mark Rutte’s People’s Party For Freedom and Democracy, winning the most votes. The next election is in France, where Marine Le Pen is expected to do well. If Marine Le Pen wins the election, there could be question marks regarding the future of the Euro.
The Eurozone’s recovery remains on track, advancing 0.4% in the fourth quarter of 2016, which is at the same pace as in the third quarter. The Purchasing Managers’ Index, which measures the economic health of the manufacturing sector, hit a 70-month high at 55.2 in February 2017. Despite the improving economy and higher inflation, the European Central Bank has left the existing interest rate and Quantitative Easing policies unchanged.
The last time Iceland was in the global financial news was during the financial crisis of 2008. Iceland has now lifted capital controls, which restricts money going into and out of the country. The capital controls were imposed after the collapse of the country’s banks, Glitnir, Landsbanki and Kaupthing. Iceland has benefited from the collapse of its currency, the Krona, with the country seeing a boom in tourism. Iceland’s economy grew 7.2% in 2016.
Following the Fed’s decision to raise US interest rates, the Bank of Japan (BoJ) has kept its existing monetary policy unchanged. The BoJ said that, “it is still far from achieving a 2% inflation goal”. Economists are looking for signs that the BoJ may have to raise its rate targets, particularly if inflation begins to take hold in Japan. However, the BoJ’s statement indicates there is little chance of a rate increase this year.
China’s government has announced that their target for economic growth in 2017 is, “around 6.5% or higher, if possible”. China’s economy is continuing to make progress, with industrial production rising 6.3% year-on-year in January-February 2017, which is up from 6% in December 2016.
Monetary policy, within China, appears to be tightening, albeit slightly, with the People’s Bank of China increasing the rate on the Standing Lending Facility by 10 basis points, and guiding the 7 day SHIBOR higher.
The oil price is one of the factors driving global inflation, with the price of Brent Crude currently at $52 per barrel, having risen from a low of under $28 per barrel. The oil price has benefited from OPEC and Russia cutting their oil supply. One factor that may be a barrier for the oil price rising significantly higher is the US shale oil industry returning to growth. The Permian Basin is now able to trade at close to $25 per barrel. The US oil output has increased by 550,000 barrels a day and could climb to over 10 million barrels per day by the end of 2018.
With the global economy experiencing a period of reflation, i.e. faster growth and higher inflation, the prospect of higher interest rates led by the US, has driven bond yields higher. The 10-year US Treasury is now yielding 2.5%. Although bond prices have fallen, taking into account the income generated, bonds are still producing a positive total return.
Although the objective of the Fed in the last year or two has been to normalise US interest rates, the Fed has often delayed raising rates due to concerns over their impact on the global economy and, in particular, the developing economies. The improving global economy, together with higher inflation, should give the Fed greater opportunity to normalise US interest rates, although it may take a significant period. In the short-term at least, the monetary policies in the US and those in Europe and Japan will diverge, but if inflation continues to pick up, the central banks within Europe and Japan may need to tighten monetary policy.