On 16/12/15 the US Federal Reserve announced it would raise short-term interest rates for the first time since the financial crisis.
The announcement, which was widely anticipated, of a rise in the federal funds rate to a range between 0.25 and 0.50%, is intended to signal the beginning of the end for the zero interest rate policy that has prevailed for the last seven years.
Exhibit 1: Goodbye to the zero lower bound ? (graph showing changes in the federal funds rate for the period between 18/12/80 and 17/12/15).
According to the Fed’s chairwoman, Janet L. Yellen, the decision to raise rates recognises “the considerable progress that has been made toward restoring jobs, raising incomes and easing the economic hardships that have been endured by millions of ordinary Americans.“
The decision to raise rates was taken with the support of all ten voting members of the Federal Reserve’s Open Market Committee (FOMC). Financial markets reacted calmly to the rate rise, which had been signalled by the Fed as imminent in recent weeks. This stoic reaction is no doubt due to the fact that the Federal Reserve has been preparing markets for this first rate hike for at least the last 18 months. Rarely has a central bank policy measure have been so widely flagged in advance. This very thorough preparing of the ground is of course very understandable – the Fed has to chart a course whereby it raises rates to reconstitute a buffer against unknown unknowns – but without taking the legs from under the current recovery.
The integration, during 2015, of a regime change in US policy rates has been a has been particularly apparent in the valuations of emerging market currencies, which have sold off heavily versus the US dollar (see exhibits 2 and 3 below). While emerging market currencies have borne the brunt of the rebooting of currency market valuations this year the US dollars’ rally has been broad based (see exhibit 4 showing the evolution of the US dollar trade weighted index).
Exhibit 2: Preparing for the take-off of US policy rates from the zero lower bound – part one – valuations of emerging market currencies versus the US dollar begin to integrate the paradigm change (first six months of 2015).
Exhibit 3: Preparing for the take-off of US policy rates from the zero lower bound – part two – valuations of emerging market currencies versus the US dollar continue to integrate the paradigm change (YTD 2015 through 17/12/15).
Exhibit 4 : The ‘broad’, trade weighted US dollar index has rallied by almost 20% since July 2014 as the foreign exchange market incorporated the paradigm change constituted by the winding down of the Federal Reserve’s zero interest rate policy.
In the view of Vincent R. Reinhart, a visiting scholar at the American Enterprise Institute and former head of the Federal Reserve’s monetary affairs division, the start of a cycle of rate hikes now is “a tactical decision on Yellen’s part to achieve her longer-run strategic aim. Hiking the funds rate, even as economic growth disappoints and inflation remains subdued, buys Yellen the credibility with her colleagues and market participants to subsequently tighten slowly. Thus, US monetary policy will remain accommodative for a considerable period.”