Rupert Seggins, Marcus WrightRBS Economics December 2015

Rate Rise: The Fed Awakens

But will the economy strike back?

The US has raised rates for the first time since June 2006. But was it needed? We

look at the following key aspects of the US economy: inflation, the labour market,

growth & the global backdrop to establish whether a rate rise was necessary.

Inflation isn’t the phantom menace…it’s just a phantom

3

Jan-05 Jan-08 Jan-11 Jan-140%

1%

2%

3%

4%

5%Inflation expectations for 5-10 years' time

Households Financial markets & finance professionalsSource: Macrobond, Cleveland Fed

• Inflation is well below the Fed’s 2% target. Headline inflation has been affected by gyrations in energy prices & dollar strength, but core has remained remarkably stable.

• Expectations are well anchored. The Fed is not even close to a credibility problem.

-2%

0%

2%

4%

6%

2005 2006 2008 2009 2011 2012 2014

PCE inflation(the Fed's favoured measure)

Source: Macrobond

Headline

Core

The labour market is pointing in 2 directions at once

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• Employment has grown for an uninterrupted 5 years. Unemployment is at a level that the Fed thinks may spark future inflation.

• But the share of people either in employment or looking for work is at its lowest since the late 1970s.

• This cannot just be explained by shifting demographics & the financial crisis.

50

55

60

65

70

Jan-48 Jan-58 Jan-68 Jan-78 Jan-88 Jan-98 Jan-08

Participation rate - 16 & over (%)

Source: Macrobond

-600,000

-300,000

0

300,000

600,000

Feb-46 Feb-66 Feb-86 Feb-06

US non-farm payroll gains (12 month average)

Source: BLS, NBER

*Shaded bars = periods of recession

Wage growth….very far from alarming

• Unit labour costs are rising, but growth in wages and salaries remains low. As in other developed economies, globalisation and technological change are holding back wage growth.

• Demand-pull inflation

doesn’t look like appearing anytime soon.

-1.5%

-1.0%

-0.5%

0.0%

0.5%

1.0%

1.5%

Average Hourly Earnings by Industry(% Y/Y Change, Difference to 8-year Avg)

Source: Macrobond

-

1.0

2.0

3.0

4.0

5.0

-3

-1

1

3

5

1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 2015

Unit Labour Costs and Wages(% Y/Y Change)

Unit Labour CostsWages & Salaries, RHS Source: Macrobond

And growth isn’t shooting the lights out

• Growth has been ticking along nicely compared to recent years. But it’s modest compared to the pre-crisis period.

• Personal consumption growth is robust, but it’s cooled a little in recent months.

0.0

1.0

2.0

3.0

4.0

1995-2007 2003-2007 2012-2015 2015

US GDP Growth(Annualised Rate, Y/Y Change)

GDP

Personal Spending

Source: Macrobond

-4%

-2%

0%

2%

4%

6%

2005 2007 2009 2011 2013 2015

US - Personal Consumption(% Y/Y Change, 3mma)

Personal Consumption

(Exc. Food & Energy)Source: Macrobond

Investment is….meh!• Fixed investment is a

similar story to spending – solid but not spectacular.

• Investment in intellectual property (around 25% of private fixed investment) has remained robust while commodity related investment has fallen. • Durable goods orders – a leading indicator of investment – are falling.

• And so has manufacturing capacity utilisation.

-40%

-30%

-20%

-10%

0%

10%

20%

30%

40%

1995-2007 2003-2007 2012-2014 2015

US Private Fixed Investment(% Y/Y Growth)

Mining & Oilfield MachineryIntellectual PropertyTotal Private Fixed Inv

Source: Macrobond

65

70

75

80

85

-40

-30

-20

-10

0

10

20

30

2005 2007 2009 2011 2013 2015

Durable Goods Orders and Capacity Utilisation

Durable Goods Orders, Y/Y Change, LHS

Capacity Utilisation (%), RHSSource: Macrobond

The global backdrop is hardly great

• The last time the Fed raised rates, China and the Eurozone were growing twice as fast as they are now. And exports were consequently booming.

• But now, global growth is stuck in the slow lane and exports are falling in volume terms.

-2%

0%

2%

4%

6%

8%

10%

Past 20 years 2004-2007 2012-2015 Past Six Months

US Exports and World Trade(Volume, % Y/Y Change)

US Export Volume

World Trade

Source: CPB

-5

0

5

10

15

US Export Growth

(Volume)

China Growth EZ Growth Global Growth

% Y

/Y C

hang

e

US Rate Rise - The Global Backdrop

Q2 2006 (Last Fed Rate Rise)

2015

Source: IMF, Macrobond, Bloomberg

China slowing and other EM concerns

• China is slowing more than the headline figures suggest.

• Its problems are structural not cyclical so the slowdown likely has a lot further left to run.

• Emerging market firms have been increasing their leverage. A significant proportion of that is dollar-denominated. Higher US interest rates potentially spells further trouble.

0

5

10

15

20

1998 2000 2002 2004 2006 2008 2010 2012 2014

Estimating China's 'True' Growth

Reported GDP

GDP 'Estimate'

Source: Bloomberg, Macrobond, RBS Economics

1.0

1.5

2.0

2.5

3.0

2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

Leverage Ratio of Corporations(Annualised Ratio)

Emerging Economies

Advanced Economies

Source: BIS

Easy does it

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• At the very least the Fed's tightening cycle is going to be extremely gentle when compared to the past. And it won't take much at all for tightening to become easing once again.

0 3 6 9 12 15 18 21 24 27 30 33 36 390%

1%

2%

3%

4%

5%

Mar-83Jan-87Mar-88Feb-94Jun-99Jun-04OIS forward curve implied

Months following 1st rate rise decision

Cum

ulati

ve p

erce

ntag

e po

int i

ncre

ase

Source: Macrobond

Trying to create some wriggle room

11

• The Fed may be looking to create room to respond to future slowdowns in growth. Especially given that it feels the unemployment rate is sufficiently low that higher inflation could be around the corner.

Feb-71 Feb-81 Feb-91 Feb-01 Feb-110%

5%

10%

15%

20%

25%

Recessions Federal Funds Target Rate

-5.00%-5.50%

-5.25%

Source: Macrobond

DenSp

a UKHun Por SA US

Aus Fin Jap Ger Ita KorCze Pol

MexSw

e BelIndia Fra

Indon BraNeth Th

ai MalTu

rRus

HK SARChina

-10-8-6-4-202468

10 Debt Service Ratios- Change since 2008, Private Non-Fin Sector

Source: BIS

Watch out Emerging Markets!• The Fed has spent much of the year preparing the ground for a rate

rise, aiming not to repeat 2013's taper tantrum. But, it will have to continue communicating its intent to gradually raise interest rates.

• Otherwise an abrupt tightening of global financial conditions could occur, an unwanted outcome given concerns over the debt loads in emerging markets.

Mainly Developed Economies

Mainly Emerging Economies

Final thoughts

• The US is better placed than other major developed economies for a rate hike. But it’s not clear that one is needed.

• The risk is that the Fed treads the well-worn path of other

central banks in places such as the Euro Area, Sweden & Switzerland. Rates rise, disinflationary forces intensify and rates have to be brought down further than before.

• There is an argument in favour of higher rates to cool asset price growth and risk-taking. But interest rates are a blunt tool for this purpose.

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