End of zero rates

In all likelihood the US Federal Reserve will abandon its wait-and-see stance this week and end the zero interest rate policy after seven years. A rate hike is warranted as the ongoing improvement on the labor market is now spawning further wage growth. The Fed is likely to stick with its message that the normalization of monetary policy will be gradual, but stress that it will react flexibly to the incoming data. The current external backdrop makes it difficult for the Fed to gauge the impact of rate hikes on financial conditions, with recent indications of a loosening of the renminbi peg to the dollar also playing a role. We see the federal funds rate climbing to 1% by the end of 2016.

The US Federal Reserve has devoted considerable effort this year to priming the markets for an initial rate hike. In the wake of the late-summer turbulence on the international financial markets the Fed surprised by remaining on hold. However, in its accompanying statement in October it stressed that it was contemplating a rate move at the next meeting of the Federal Open Market Committee (FOMC). And the speeches by Fed president Janet Yellen early this month also suggest that she now considers the conditions set out to date for beginning the policy normalization process as having been met (“some further improvement in the labor market” and “sufficient confidence” that inflation was heading back towards 2%).

Since the October meeting of the FOMC there have been two further labor market reports. Following a more subdued performance in August and September, they show jobs growth clearly regaining momentum despite the ongoing weaknesses in the manufacturing sector (dollar strength) and energy production (oil price slide). On balance the increase in jobs in the second half of the year up to November is only little changed on the solid trend seen in the first six months of this year. At 211,000 of late, jobs growth is almost 100,000 jobs above the level needed to keep the unemployment rate stable over the next twelve months given the current labor force participation rate and growth in the working-age population to date. So the prospect remains that the unemployment rate will fall well below the current level of 5% in the coming months. The current level is already viewed by the Fed as normal. In September the FOMC participants’ central tendency projection had foreseen a drop in the unemployment rate to 4.8% by the end of 2016. The updated projections could see this figure lowered further, assuming the central bank representatives are not expecting an appreciable rise in the participation rate and/or an abrupt slowdown in jobs growth.

Unlike the unemployment rate, the core inflation rate of the price index for personal consumption expenditures at 1.3% is still not mandate-consistent (2%). Low import prices on the back of the exchange rate are playing a role here. However, expectations within the FOMC that inflation is heading up are likely to have risen in view of growing evidence that domestic inflationary pressure is building, evidently in conjunction with the improvement on the labor market. Average hourly earnings for all private sector employees appear to be tending upwards and are poised to see an increase of 2.5% on a year earlier this quarter, having risen more or less constantly by 2% in recent years. The upward trend is even clearer of late in labor compensation per hour in the non-farm business sector, which includes ancillary costs. Revised figures for the second and third quarters show an annualized increase of 5.6% and 4% respectively. On average in 2015 they look set to rise by 3%. With productivity gains remaining subdued, unit labor costs could rise by 2% again this year. Surveys among small companies also point to higher wage rises, with the proportion of companies planning to raise compensation rising in November for the third month in a row and reaching the peak seen in the previous cycle.

Following the likely rate hike, the markets will increasingly focus on the rate path signaled by the Fed. Basically, the message that monetary policy normalization will be gradual in the years ahead is likely to remain in place. The Fed has been stressing this in its statements for a while now, pointing out that economic conditions are likely to warrant keeping rates below what is deemed to be the long-term neutral rate (median figure in the Fed’s September projections: 3.5%) for some time even after unemployment and inflation reach mandate-consistent levels. The Fed has thus so far been working on the basis that the equilibrium real rate, i.e. the short-term rate that is compatible with the economy operating at full potential and a stable inflation rate, remains extremely low.

In one of her recent speeches Janet Yellen listed a host of reasons for this, including weak productivity growth to date and low growth among key trading partners in conjunction with the substantial appreciation of the US dollar. On top of this, estimates of the current level and the future trend in the “neutral” short-term rate were highly uncertain as precise figures were hard to pin down. Given this uncertainty, the Fed, in contrast to the last rate-hiking cycle, is likely to forgo any pointers to a definite pattern of rate adjustments, but stress that it will react flexibly to the incoming data.

Given the tricky external backdrop, we assume that the shift in monetary policy will be gradual. For the end of 2016 we are penciling in a target corridor for the federal funds rate of 0.75%-1%.


Michael Heise
Phone +49.89.3800-16143

Thomas Hofmann
Phone +49.69.24431- 4912

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