Analytical commentary

The US interest rate rise last December was widely expected for a number of reasons. The US economy needed to begin the process of normalizing interest rates. Keeping rates near zero has caused too many asset price distortions. Although inflation has remained low in the US, two developments in the economy make it imperative to be alert to inflationary pressures down the road.

Asset Price Distortions. With interest rates near zero for nearly a decade, real financial asset prices have been difficult to discern. That is a major reason why such volatility has been observed in both stock markets and bond markets around the world. Now it is clear that US interest rates will rise further, the question is – how far and how fast will that rise be. No matter when the Fed would have begun to raise rates, such volatility would still have been seen. Postponing a rate rise would only have postponed the financial asset re-pricing now underway.

NAIRU. There are two developments, which have the potential to rekindle inflation in the US. Although both are representative of a healthy US economy, when and if they occur simultaneously, they would likely have a negative effect on inflation.

The US economy is at or very near full employment. Economists have an acronym for that unemployment rate — NAIRU or the “non-accelerating inflation rate of unemployment.” Basically what that means is that when the unemployment rate goes below a certain level, it begins to trigger domestically generated inflation.

The most recent unemployment rate was 4.9 percent. Most economists agree that in the case of the US, NAIRU is somewhere between 4.5 and 4.9 percent. That means that the economy is at or very near a rate of full employment. For the first time in years real wages are rising, and at a slightly accelerating rate.

Full Capacity. Also, according to most estimates, the US economy is poised to reach full capacity utilization during sometime in 2017. Full capacity utilization usually triggers price rises. Although the price rises would be mitigated by higher import levels, that substitution process is never efficient in the near-term.

The US economy is rapidly approaching a combination of full employment and full capacity utilization, and there are signs that inflation is already making inroads in the US.

The CPI. The headline rate of inflation is extremely low. However, on closer examination when volatile energy and food prices are excluded, it can be seen the CPI rose by 2.2 percent in January year-over-year. That is already slightly above the Fed’s 2 percent target rate of inflation.

Food prices are always volatile, depending on the weather. Energy prices are volatile as well. However, from the US perspective, once energy prices stop falling, then over time, the CPI excluding energy will rise closer to the 2.0 percent target rate.

Fed Conundrum. This was and remains the conundrum facing the Fed. To begin normalization was a must. Determining the pace and level of rate rises is more complex. The Fed needs to keep economic growth at a pace consistent with growth in capacity, which means growth in investment.

In recent months it can be noted that firms are cutting back on their investment. Many are doing so because overseas profits are down from a combination of a higher dollar making those foreign earnings worth less than before, and a faltering world economy, which hurts demand for American products and services. Therefore, although the US economy continues to perform well, domestic investment will be slower because of these two factors. That implies that capacity might not be added at a rate consistent with postponing the date when full capacity utilization is reached.

As such, the Fed must be poised to raise rates this year and next. However, the Fed should only raise rates when it is sure that the economy is getting nearer to full employment and capacity constraints. It can be argued that since the Fed won’t get real GDP growth for the first quarter of 2016 until April, and since the first quarter’s numbers will likely be skewed for complex seasonal adjustment factors, the Fed won’t have a really good idea how the economy is performing until the end of the second quarter. That means the data won’t even be available until July. Therefore, unless something dramatic occurs, it is unlikely the Fed would raise rates again before mid-summer at the earliest. Even then, the economic picture will not likely be so clear as to justify a rate rise. So, it seems that US rates will likely not rise until the fourth quarter of 2016. Rate rises in 2017 will depend on the same factors as in 2016, implying cautious rate rises next year.


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Maria Mukhina
Operating Director
+7 (495) 139 04 80, ext. 107
Natalia Porokhova
Senior Director, Head of Sovereign Ratings and Forecasting Group
+7 (495) 139 04 90
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