Interesting Interest Rate Impasse (Part II)

 

The U.S. Central Bank (the Federal Reserve or ‘Fed’), is widely expected to increase its headline interest rate this year. There is no doubt that this will have a knock on effect to the UK, which is likely to follow with similar action. This clearly has lasting implications for anyone with a mortgage or bank based savings……that’s a huge slice of the UK affected by US interest rate actions.

 

Put simply (probably patronisingly), Central Banks use interest rates to affect the economy and to control inflation. The US rate is currently set at 0.25% and has remained there for around 7 years. The International Monetary Fund (IMF) believes a US rate rise in early 2016 will be suitable but the Fed is widely expected to increase later this year instead following their September meeting.

 

The interesting thing about interest rates is the impact of a rate change does not come from the rate change itself but rather from market expectations about future rate changes.

 

Since the US rate has been so low for so long any increase at all (however slight) will signal a shift in US monetary policy. The immediate impact is households will have less disposable income and businesses will face increased borrowing costs, which will make some projects appear unfeasible. The medium term impact is both households and businesses could put off some of their spending until they get a clearer idea of how frequently these rate increases will come and what size increases we will see.

 

Some commentators are concerned that financial markets, particularly US shares, could experience a fall as they have been kept buoyant by the low interest rate environment. Another concern is the US economic recovery, which has been strong but is still not booming, may slow down which could cause the US to enter a period of slowing or falling economic growth.

 

Of course all of this is factored in by The Fed. This is why any interest rate rise will only take place when the fundamentals are correct……after all, nobody (particularly US policymakers) wants to see falling share markets and slowing economic growth. Any interest rate change will be designed to support a growing economy while also allowing for the fact that rates simply can’t stay low forever.

 

Interest rates are a very useful policy tool for Central Banks, one they don’t want to do without. If the US was to enter a recession tomorrow (with interest rates at 0.25%) the Fed would have no scope to cut rates in order to stimulate economic growth……it would be like going into a fight with one hand tied behind your back. It logically follows that the faster the Fed can raise rates, the easier it can cut them again in the event of a downturn. The trick is to balance increasing rates without causing a slowdown in key economic indicators such as unemployment and economic growth figures.

 

While no-one expects rates to shoot up, this is likely to signal an end for ultra-low interest rates (for now at least). The longevity of these higher interest rates will depend entirely on the continued strength of the global economic recovery.

 

But remember one thing……when the US sneezes, the UK catches a cold.