June 20, 2016
The Fed keeps rates
unchanged in June. Our scenario of, “Lower for Longer” appears to be
gaining traction as strong headwinds from abroad and mixed domestic indicators
have at least temporarily halted the Fed’s normalization strategy which began
in December 2015.
The Fed has a dual mandate to achieve a particular inflation
rate as well as maximize employment. The latest developments of the US economy
over the past six months have been mixed and prolonged weakness in economic activity abroad could mean that the interest rate required to keep
the economy stable would be lower. The Fed pointed to some particular
headwinds which informed their decision to put rates on hold. However, Chair Janet Yellen expressed concern that these headwinds
are expected to persist over the next few years which would lead to lower
- Inflation. The core PCE inflation indicator which the Fed targets at 2% was 1.6% YoY in April. Despite inflation tracking upwards somewhat most indications regarding inflation expectations have actually been dropping.
Latest job gains slowed markedly, adding a mere 38,000 jobs in May, the lowest
in six years.
- Weak growth abroad. The global growth outlook has worsened only a little bit based on the April IMF WEO. However, the risks are placed firmly on the downside as uncertainty about China’s slowdown remains high and low growth in Europe continues to materialize.
- Subdued household formation. Despite some positive signs in the labor market, such as lower unemployment, subdued household formation suggests confidence remains weak and perhaps some major slack in the labor market still exists.
productivity growth. Since the end of 2015, productivity has declined. If
productivity does not rebound, then potential GDP growth will correspondingly
remain subdued and the natural interest rate to support higher potential would
need to be lower for longer.
Generally speaking, a strong and healthy US economy is
associated historically with strong performance in emerging countries. However,
persistent cycles of USD appreciation or depreciation can have mitigating or
amplifying effects on real GDP growth in emerging markets.
Simply because interest rates in the US would be
lower for longer than previously assumed would not necessarily induce a robust
recovery in emerging market currencies. It is true that lower
long-term interest rates in the US would induce some financial movement into
emerging markets as investors seek higher returns. In turn, the greenback may
depreciate which will help boost commodity prices and lead to higher income for
commodity-based countries. However, weaker global demand will certainly be a
mitigating factor which keeps commodity prices and economic growth in emerging
markets from returning to the relatively high levels achieved before 2015.
The economist responsible for this story: Jared Laxton
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