To hike or not to hike; that is the question

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To hike or not to hike; that is the question.

Larry Williams:
Let's talk about the U.S. Federal Reserve hike rates this week and will they or won't they? It's probably worth first explaining why the U.S. Federal Reserve might feel compelled to lift the Fed Funds Rate this week.

David McLeish:
As I know you can appreciate Larry, there are a wide range of reasons, both economic and otherwise, as to why the Federal Reserve might choose to raise their overnight cash rate. But the official line from them goes something like this; the Federal Reserve raises interest rates to slow the economy down and stop it from overheating. This is because an overheating economy could cause inflation to rise sharply if left to its own devices.

Larry Williams:
Is there enough evidence to suggest the U.S. economy is close to overheating?

David McLeish:
That's again a highly debated topic, simply because monetary policy operates with a time lag. In theory the Federal Reserve shouldn't wait to hike interest rates until the economy has reached full employment for example. This is because by then inflation will be very hard to contain.

The problem is though that the reliability of previously so-called "leading indicators" is being strongly questioned at the moment. An example is that since commodities are the basis of everything that is bought, consumed or otherwise utilised; if inflationary pressures were really on the rise, commodity prices should already be on the rise, and this clearly isn't the case.

Larry Williams:
You commented that there were some non-economic reasons why they might raise their overnight interest rate on Friday morning. What are they?

David McLeish:
That's right. The most obvious non-economic reason per se is that the Federal Reserve itself recently admitted that Quantitative Easing (or money printing) didn't work in lifting economic activity or inflation as they thought it would. With no other obvious options available to them in order to boost economic activity at the onset of the next downturn, they need to get their overnight cash rate up, so it can then be cut again when the economy needs it most.

The other non-economic reason is the Federal Reserve's own credibility. It keeps moving the goal posts, or conditions for a rate hike. Some may remember when the condition for a rate hike was a 6.5% unemployment rate; we are now well below that at just 5.4% and still no hike.

Larry Williams:
It's clear there is a lot of conjecture out there. What do you think they will do and is it the right decision in your opinion?

David McLeish:
It really is a 50/50 call. But if I had to choose I'd say they will hold off for now. Only because I think the voting members of the Open Market Committee are lacking a consensus on if the U.S. economy really is on its way back to their 2% inflation target. With the risks of being too quick to hike greater than the risks of holding off this would be the right decision for now, in my opinion.

I would just say though that regardless of what they decide to do in the near term, it is likely to be one of the slowest hiking cycles in history. And what's more, the next peak in their overnight cash rate will be the lowest of any cycle before it. We can't forget that this current U.S. economic recovery is already one of longest in history and is already looking a little long-in-the-tooth.   

Larry Williams:
What are the implications for New Zealanders?

David McLeish:
Well many of your listeners will remember just last year that our own Reserve Bank was hiking the Official Cash Rate at the same time that the U.S. Federal Reserve was doing the opposite through printing money. While it has been more likely in the past that both central banks would be moving in the same direction, recent history tells us that they don't always have to, at least in the short-term. So the read across for what this means of our own interest rates is limited in my opinion.

As was the case last year, when the Reserve Bank was hiking our OCR, the impact was most prevalent in the currency markets where the New Zealand dollar appreciated against most other major currencies. The same is likely to be true this time around but in reverse.

While a lower New Zealand dollar will help stimulate our local economy I don't see it holding the Reserve Bank back from cutting our Official Cash Rate further over the coming months.


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