What do we know about the likely course of US interest rates after the Federal Reserve Board meeting that we did not know before? And what does it mean for the interest rate outlook in Europe?
Had the Fed, the US central bank, not increased interest rates, there would have been huge shock in the markets. Investors had been well prepped for the 0.25 of a percentage point rate increase, bringing the target for the Fed's key short-term rate to between 0.5 per cent and 0.75 per cent. However the tone of what the Fed said - and its forecasts for 2017 - were a bit more hawkish than had been expected.
It is the second Fed increase since 2006, before the crisis hit. The first one came this time last year – and the expectation then was that there would have been several more in the meantime. In the event, market wobbles early this year stayed the Fed’s hand, and then it avoided a rise immediately before or after the presidential election.
Election
Following the election of Donald Trump, the financial markets are betting on higher growth and higher inflation in the years ahead. And this would mean, in time, higher interest rates. Already long-term US bond market interest rates have risen sharply and are at their highest levels since 2010.
The Fed has now indicated that it, too, believes inflation is on the rise and that interest rates should start to march higher in response. Federal Reserve Board key committee members now on average expect three rate rises next year , compared to two previously. Fed chair Janet Yellen argued that this was a “minor” change. But it will add to the market view that interest rates are now firmly on the up, and it was significant that Yellen said that at least some of the members of the key Fed committee had taken into account the likelihood of changed tax and spending policies in their predictions.
Now these predictions may well be wrong – this time last year the governors expected four hikes in 2016. A lot will depend on how the US economic data plays out in the months ahead. But the Fed’s move will only add to the mood in the markets that the Trump presidency will usher in an era or higher interest rates and higher inflation.
ECB
For Europe – and Ireland – this does show that the interest rate cycle will eventually turn, even if questions remain about how quickly ECB rates will rise, given the low level of inflation and inflation in Europe.
European long-term interest rates, particularly for periods of five years or more, have already started to move off their lows – and as US long-term rates head higher this will influence Europe, too.
If inflation shows signs of rising in 2017, this trend may accelerate.
However the first increase in short-term ECB interest rates is still thought to be a way off – possibly not till 2018 on the basis of current market trading. This could change. But the lessons from the US are twofold. Yes, the interest rate cycle does turn. But even then increases can be slow in coming -–and no one is quite sure what the new normal will be for interest rates in the post-crisis world. The Fed governors expect rates to get close to 3 per cent by 2019. But who knows?
After all, seven years into an economic recovery, US rates are still below 1 per cent.
