Rate-lifting in the US. And why it matters for the UKRupert Seggins & Marcus Wright

RBS Economics (@RBS_Economics)

September 2015

Before the FOMC meeting, markets put a 64% chance on the first rate rise happening this year

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But too much focus on this misses a bigger point. US rates could stay lower for longer.

‘Lower for longer’ doesn’t necessarily mean interest rates cannot go up. It can also mean central banks trying to raise rates a little, before seeing them forced back down soon after.

Sep-15

Oct-15

Nov-15

Dec-15

Jan-16

Feb-16

Mar-16

Apr-16

May-16

Jun-16Jul-1

6

Aug-16

Sep-16

Oct-16

Nov-16

Dec-16

Jan-17

Feb-17

0%

10%

20%

30%

40%

Probability 1st rate rise happening in*...

Source: Bloomberg. *Blank entries are months in which there is no FOMC meeting

Jan-90-6%

-3%

0%

3%

6%

9%

Where the Fed Funds rate is and where it "ought" to be

Fed Funds rate that reflects QE Fed Funds RateMankiw Rule

Some traditional rules of thumb say rates should have risen already

3Source: Macrobond, Mankiw (2001), Wu & Xia (2014). Mankiw rule estimated using period 1990-2008.

About 2.5%

4Source: Bloomberg

There is about a 1-in-4 chance that US rates won’t have risen beyond 0.5% by mid-2018

And even if the Fed follows the central expectation, rate rises will be very gradual. Over-focussing on the first rise misses the bigger picture.

5

Why lower for longer?

Four things making the Fed think twice

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Inflation is below target Inflation expectations are stable

Above average underemployment Earnings growth is not surging

Jan-05 Jan-09 Jan-13-3%

0%

3%

6%US inflation expectations for 5-10 years' time

Households Financial markets & finance professionals

Jan-00 Jan-03 Jan-06 Jan-09 Jan-12 Jan-150%

5%

10%

15%

20%

Rate of un- and under-employment

Jan-08 Jul-09 Jan-11 Jul-12 Jan-14 Jul-15-2%

0%

2%

4%

6%

PCE inflation (the Fed's favoured measure)

Mar-07 Mar-09 Mar-11 Mar-13 Mar-150%

1%

2%

3%

4%

Average hourly earnings (%y/y)

Source: Macrobond, Bloomberg

Source: Macrobond, Bloomberg

China is a big disinflationary force for the world

• Chinese export price inflation explains a lot of what’s going on at the moment

• Cheap goods from China were a key factor in the pre-crisis world of low inflation, low interest rates and increased risk-taking. They still are.

• China’s slowdown has so far led to a drop in oil and raw materials prices and a world trade recession. Both mean less inflation for us.

0

10

20

30

40

50

60

70

1971-85 1986-98 1999-2013

Causes of Inflation Variability in Advanced Economies (%)

Inflation variability caused by the same common factorInflation variability caused by Chinese export prices

Source: Financial Stability Board, Macrobond, Bloomberg

Quantitative easing is going to continue in Europe and Japan

Central banks are keeping rates down by buying up government bonds (Quantitative Easing or QE). While QE may have come to an end in the US and the UK, the European Central Bank will be carrying on until Autumn 2016. The Bank of Japan’s programme is open-ended.

020406080

100120140160180200

2009 2010 2011 2012 2013 2014 2015

Central bank purchases ($Bn)

Fed Bank of EnglandBank of Japan Bank of Japan Forecast PurchasesECB ECB Foreast Purchases

9Source: Bloomberg, Macrobond

Recent history may worry the Fed

Turkey (Jan-14)Denmark (Apr-11)Eurozone (Apr-11)

N. Zealand (Jun-10)N.Zealand (Mar-14)

Sweden (Jul-10)Chile (Jun-10)

Hungary (Nov-10)Poland (Jan-11)

Korea (Jul-10)Australia (Oct-09)

Israel (Aug-09)Norway (Nov-09)

Iceland (Sep-11)Canada (Jun-10)

477

915

1719

2122

24252526

3855

Number of months from 1st rate hike to first rate cut

Of the OECD central banks that raised rates after 2008, all have either lowered or begun to lower them again

10

Why is this important for

UK interest rates?

The Fed & The Bank of England – peas in a pod

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Nov-72 Nov-82 Nov-92 Nov-02 Nov-120%

5%

10%

15%

20%US & UK policy interest rates

Bank Rate Fed Funds Target Rate

Source: Macrobond

This is not surprising considering: 1) how much UK trade and finance goes to the US and back 2) the US’ position at the centre of the world financial system.

US borrowing costs influence UK ones

12Source: Macrobond

Whatever the Bank of England does, many of our interest rates could be affected anyway. For example, UK government bond yields track US yields closely.

Jan-57 Jan-67 Jan-77 Jan-87 Jan-97 Jan-070

5

10

15

20US & UK 10 year government bond yields (%)

UKUS

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