That much anticipated September meeting last week concluded with the Federal Reserve erring on the side of caution by not increasing interest rates.
The risks posed to the US economy from recent global macro and financial market developments were a key determining factor in the Fed’s decision.
The meeting statement noted that “recent global economic and financial developments may restrain economic activity somewhat and are likely to put further downward pressure on inflation in the near term”.
In her post-meeting press conference, Fed chair Janet Yellen said the decision to remain on hold was “in light of the recent heightened uncertainties abroad and a slightly softer than expected path for inflation”.
However, at the same time, she was keen not to “overplay the implications of these recent developments” and stressed that the events have not “fundamentally altered” the Fed’s outlook.
Indeed, the Fed indicated that the “economy has been performing well” and it expects it to continue to do so.
The Fed’s economic assessment is backed up by recent data, which points to solid growth in the US. The release of second quarter GDP figures showed that the economy grew by 3.7% on an annualised basis.
This represents a marked improvement from the 0.6% growth registered in the first quarter. The breakdown of the growth data was encouraging, with all of the main sectors of the economy providing a positive contribution.
Data for the third quarter suggests that the economy has maintained its improved pace of growth. For example, survey data such as the key services sector ISM index averaged 59.7 in July and August compared to its second quarter average of 56.5.
Most hard data measures of the economic performance in recent months have also been encouraging. This includes retail sales data, as well as indicators from the housing market.
The solid performance of the US economy has continued to have a positive impact on the labour market. Employment growth has remained robust averaging above 200,000 in the first eight months of this year. The unemployment rate fell to 5.1% in August, its lowest level since April 2008. However, wage growth has remained quite modest.
On the inflation front, lower oil prices have seen the annual CPI rate remain very subdued, coming in at just 0.2% in August. Meantime, core PCE, the Fed’s preferred measure of inflation, was stuck at 1.3% in the second quarter, still a way below its 2% target rate.
And herein lies the key dilemma for the Fed in its policy deliberations on when to increase interest rates. A good deal of activity indicators from the US economy suggest that now could be the appropriate time to start hiking interest rates.
However, at the same time, inflation remains very subdued, with factors such as the recent strength of the dollar and the the lower energy prices keeping downward pressure on it.
While the Fed views these factors to be transitory, a complicating factor now for the Fed is the high degree of uncertainty about the economic outlook as a result of recent global macro and financial market developments, mainly to do with China.
This has prompted the Fed to hold fire for the time being. Indeed, Ms Yellen said that “given the significant economic and financial interconnections between the United States and the rest of the World, the situation abroad bears close watching.”
Overall though, the Fed continues to indicate that it expects rates to rise later this year, while at the same time stressing that the pace of rate increases will be gradual in this tightening cycle.
With two meetings left before year end, the December meeting seems the more likely starting point than October.
Of course, this is dependent on the Fed becoming satisfied that the risks to the US economy from developments abroad are abating as well as a further improvement in the US labour market.
John Fahey is a senior economist at AIB
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