US Interest Rate Hike: a Matter of When, not If

US Interest Rate, rate Hike, Matter, When, not If, Fundamental Analysis, fx trader, forex

14 Jul 2015

The issue that has preoccupied the currency market more than anything else this year – aside perhaps from the Greek debt issue – is when the world’s largest single-country economy will raise interest rates. It’s the same for the majority of Forex traders who are monitoring the long-term strength of the US dollar. At this moment in time, there seems to be a consensus amongst economists and commentators that an interest rate rise is not a question of if, but when.

The US Federal Reserve Bank has not increased the Fed Funds Target Rate since June 2006. Exactly when they will do so depends on the health of the economy, as reflected by the data. The Fed have said they won’t begin lifting their benchmark federal funds rate from near zero until they see more improvement in the labour market and are confident inflation will rise toward their 2% target.

Data is king, not speculation

The Fed are data dependent, and the last two months of data has been, on the whole, positive. Quarter one data was poor overall and the Fed attributed this to transitory factors in their April statement. Thus far they have been proven correct; data has improved and of note was the Core Consumer Price Index readings for April which came in better than expected, showing an increase of 0.3% for the month. Since that positive reading we have seen the CPI readings for May, which showed core inflation rose only 0.1% for the month, slightly missing estimates. Nevertheless, in annualised terms the last two months’ of core readings amounts to a core inflation rate of 2.4%, which is actually above the Fed’s target of 2%.

Inflation has been the weakest link for all major economies this year, since the massive drop in oil prices, and the US has been no exception. It’s within the context of low inflation that the positive Core CPI readings for April become so important. The core reading of 0.3% m/m is the highest since January 2013. Although the most recent readings for May have dropped back down to 0.1%, this may still be the start of an upward trend. Annual core inflation is at 1.7%, which is only 0.3% below the Fed’s target. In normal times the target inflation rate would refer to the total CPI however given the considerable drop in oil prices, the Fed are more focussed on core readings. The Fed have stated: “Core inflation measures that leave out items with volatile prices can be useful in assessing inflation trends.” An annual core CPI reading of 1.7%, up from 1.6% at the start of 2015, may suggest that inflation is on its way back to 2%, as the Fed requires.

Throughout 2014 the employment situation was healthy and unemployment gradually dropped to where it now is at 5.5%, slightly up from the prior month where it hit 5.4%, which was the lowest since 2008. However it is also wage growth that the Fed want to see increase. The recent reading, for May, showed average earnings better than expected at 0.3%, up from 0.1% in April. This rise sends a strong signal about improvements in the labour market that the Fed have said they are monitoring to inform their rate decision.