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Fed's rate raise a nod to uncertainty

Lex Hall  |  20 Dec 2018Text size  Decrease  Increase  |  
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The US Federal Reserve has voted unanimously to raise the costs of borrowing for the fourth time this year. The decision was largely expected and the Fed did not disappoint, voting to raise its target rate range to 2.25 per cent-2.5 per cent.

For Morningstar analyst Eric Compton, the Fed is acknowledging some of the uncertainty in the economy and the effects of future hikes, and is leaving the door open to slow down future rate increases. However, Fidelity International global economist Anna Stupnytska says the decision is too optimistic, and suggests that pausing to assess is a wiser course of action, which avoids the risks of overtightening.

Locally, AMP Capital's chief economist Shane Oliver expect the Fed to pause in the first half next year and only raise rates once in the second half.

US Federal Reserve interest rates borrowing

A nod to uncertainty: Morningstar analyst Eric Compton

"There was again a slight change in the language of the release as well as a more dovish looking dot plot," says Compton. "The FOMC’s statement maintained its language that further hikes would be gradual and that the risk outlook remains roughly balanced; however, the committee replaced the word 'expects' with 'judges' when describing how it thought about the effect of these further gradual rate hikes on the economy and inflation.

"We conclude the Fed is giving a nod to some of the uncertainty regarding the economy and the effects of future hikes and is leaving the door open to slow down future rate increases."

The dot plot has also shifted, with many of the higher rate dots shifting down, creating a lower projected median rate. The 2019 median projected rate is now 2.9 per cent, down from the 3.1 per cent rate given at the September meeting, and the longer run median rate is now projected at 2.8 per cent, down from 3.0 per cent.

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Compton says CME futures data further reflects this shift, and is in fact even more dovish than the Fed, with the highest probability given to zero rate hikes in 2019.

"Overall, our long-term rate projection remains intact, where we expect a normalised policy rate of roughly 2.75 per cent to be reached in the next couple years. We would expect overall net interest margins to increase at a reduced pace regardless, as competition picks up among banks. We are leaving current fair value estimates in place for all our banks.”

Too optimistic: Fidelity's Anna Stupnytska

"The Fed's assessment of the economic outlook for next year is still somewhat too optimistic," Stupnytska says. "I expect the US economy to slow to about 2 per cent or just below that in 2019, which is far from recessionary and roughly in line with trend but below the Fed’s forecast.

"I believe a 'pause and re-assess strategy' at some point next year would serve the Fed well. With some one-off data distortions in a number of important global indicators in H2 2018, including data from China and the euro area, more clarity is needed on the direction for the global cycle, which would in turn help set the tone for markets."

Stupnytska says the Fed evaluate the effects of the fading fiscal stimulus combined with the recent tightening in financial conditions on the economy. "These existing headwinds might well be sufficient to prevent the much-feared overheating, releasing some pressure in the labour market. 

"To its credit, the Fed has managed the policy normalisation process relatively smoothly so far. But at this point of the cycle, a small misstep can override the achievements to date. Pausing to evaluate the situation, even if it results in overshooting inflation target (still a big if!) will not be as costly as overtightening and bringing the economic expansion to its end."

Not dovish enough: AMP Capital's Shane Oliver

"However, with US interest rates approaching the 'neutral' zone, some interest sensitive sectors slowing, with various headwinds to growth, and inflation stabilising around 2 per cent the Fed can afford to slow down from here. We expect it to pause in the first half next year and only raise rates once in the second half," Oliver says.

"A more cautious Fed should provide some support for markets although more falls are possible into early next year before markets bottom and head higher as investors realise the US/global economy is not going into recession soon."

is senior editor for Morningstar Australia

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