US Fed set to cut rates to 5% by mid-year
Rates went on hold at the next meeting in August, bringing to an end a run of 17 quarter-point interest rate rises, thus taking rates up from 1% in June 2004. Since the Fed went on hold last August, it has maintained a bias towards higher rates, reflecting its concerns about the risks of higher inflation in the US economy.
Financial markets believe the Fed will maintain its interest rate stance until closer to the end of 2007, with a cut of no more than 0.25% priced in at this point.
In taking the decision to pause rates at 5.25% in mid-2006, the Fed forecast the economy would grow a little below its potential until the end of 2007. US potential growth is estimated at about 3%. The economy has grown well below this rate since the second quarter of last year, averaging a quarterly annualised rate of 2.3% in the second and third quarters. We still await data on the final quarter of 2006, but real GDP is unlikely to have grown by more than 2.5%.
In his semi-annual report on monetary policy to the US Congress in July 2006, Fed chairman Ben Bernanke presented a central forecast which stated the US economy would grow 3%-3.25% in the year to the fourth quarter of 2007. Based on trends to date, it would appear growth will fall short of this forecast. A more likely outcome is an annual growth rate of 2.5%.
However, the Fed is expected to stick to its stance as the labour market has remained strong. Employment growth has been steady at about 1.5%, with total hours worked growing by over 2%. The unemployment rate is 4.5%, meaning the economy is close to full employment.
Furthermore, in its latest assessment, published last week, the Fed described labour market conditions as tightening in many parts of the economy.
The Fed is not expected to signal a change of policy until the labour market shows signs of widespread weakening. While there are signs of weakness in construction and manufacturing, the services sector remains strong.
Over the past few months, economic indicators have pointed to moderate economic growth with no immediate sign the slowdown in the housing market is having a significant effect on the rest of the economy.
Confidence has been boosted by the warmer weather and the fall in crude oil prices, however there are risks of sizeable second-round effects from the housing downturn which could be felt later in 2007.
On the inflation front, there are tentative signs that pressures are easing. Though most measures of core inflation are above the Fed’s comfort zone, the recent monthly trends in the core CPI point to an annualised rate of about 1.3%.
While the CPI is a recognised measure of inflation, the Fed prefers to gauge inflationary pressure on the basis of movements in the deflator for personal consumer expenditure (PCE). On this basis, inflation is still within a 2.25%-2.5% range, which is above the Fed’s unofficial target rate of 1.5%. Inflation is a lagging indicator, responding in time to the slowdown in the economy. As a result, it may take several months before inflation finally moves down and allows the Fed to indicate a change of policy.
The Fed’s policy setting body, the Federal Open Market Committee, meets at the end of the month. Policy is not expected to be changed significantly. We may have to wait until its meeting in May before there is any indication of a softening in policy.
The Fed is in a comfortable position in that its stance is not overly restrictive. Since it began to tighten policy in mid-2004, the stock market has risen, the overall value of the US dollar has fallen and longer-term rates have remained low and in a narrow range, all of which suggest that financial conditions are not too tight.
We continue to believe the Fed will cut rates to 5% by mid-year. If, as we expect, the economy grows by no more than 2.5% in 2007 and inflation has eased, the appropriate official US interest rate by end-2007 would be below 4.5%.
