Lower U.S. Rates for Longer No Panacea For Emerging Market Currencies

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 interest rates.

Dual Mandate

- 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.

- Employment. Latest job gains slowed markedly, adding a mere 38,000 jobs in May, the lowest in six years.

Headwinds

- 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.

- Low 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.

Emerging Markets Impact

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.

Opinion

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