Posted by

Sukhdeep Dhillon

14 Sep 2015

Since the Federal Reserve - the US' central bank - announced that its policy stance after June will be data determined, all data on US economic activity is now watched and analysed even more carefully than usual.

So how has the US economy been performing?

US economic growth slowed in the first three months of 2015 - gross domestic product (GDP), the widest measure of growth, rose by just 0.2% from the previous quarter. Many experts believed this was a blip and growth would pick up. The same winter blip happened last year when the economy actually contracted by 0.2% in the first quarter of 2014 compared to the previous quarter, but the economy came surging back as the weather improved.

The second quarter GDP figure was recently revised upwards to 0.6% compared to the previous quarter. The US economy, led by the housing recovery and increased corporate spending, powered a large portion of the second quarter GDP revision. Most positive was business investment growing by 3.2%. Net exports also boosted GDP, as imports fell. This was backed up by increased government spending, especially at the state and local level. Other pockets of good news show the past few weeks of US weekly initial jobless claims declining to the lowest levels seen in many years – around 270 000. 

Will they won’t they?

The Federal Reserve last raised rates in June 2006, by 25 basis points to 5.25%. It soon found itself reversing course, as the housing crisis gave way to the recession; since December 2008, the Fed's benchmark interest rate has been set at between 0.0% and 0.25%. That may be about to change.

The Federal Reserve set monetary policy in order to meet mandates for maximum employment and stable prices. The Fed has determined that the best way to meet those mandates is to target a rate of inflation of around 2%.

Why? Because, when the economy is weak, inflation will fall, while when the economy is close to maximum employment, rising wages will push up inflation. Keeping inflation near 2% should therefore keep the economy growing at a healthy rate. The Fed raises its benchmark interest rate when the economy is growing too fast; that encourages people to spend less and save more, which slows the economy down and reduces inflationary pressure.

The Fed is beginning to believe it is appropriate to begin raising rates. Its preferred inflation gauge is still well below the 2% target; in the year to July it rose just 0.3%. The US job market has been booming and the unemployment rate, at 5.3%, is close to levels at which Fed officials expect wage increases to accelerate.

Nonetheless, raising rates is risky. The move toward Fed tightening (a course of action undertaken by the Federal Reserve to constrict spending in an economy that is seen to be growing too quickly, or to curb inflation when it is rising too fast) can destabilise global markets.

The mention of Fed tightening brings back painful memories of past emerging markets crises - the tightening cycles of US monetary policy in 1994 and 1999 helped trigger the crises in Mexico and Asia, with significant damage to both economies and asset prices.

Rate rises must therefore ensure that the factors which have been dragging down inflation are not temporary.

The great interest rate conundrum

If the Fed waits too long to raise rates then inflation could rise to 3% or 4%.

If the Fed hikes rates too soon, then very low inflation might quickly become deflation, and the Fed will have little room to cut interest rates before returning to zero.

Many experts believe the Fed is prepping for an October rate hike. But what matters more than the timing of the first hike is what the Fed does next. Will it follow action in October with more rate hikes in subsequent months? And if so, how many percentage points will the Fed go for?


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