The US Fed’s plan for Rate Hikes and the resulting fallout in 2017

Donald Trump’s election has increased the expectation further Federal Reserve rate hikes. The recent hike in the Fed’s interest rates, only the second such hike in the past decade, may be the foretaste of up to Three further rate hikes during 2017.

FRB

 

Trump’s  campaign platform was based on stimulus policies that would both increase economic activity — through infrastructure investment,  corporate tax  cut to 15%,raise tariff barriers to imports resulting in  boosting prices domestically. Such plans on the back of interest rate rises are recipes for higher inflation.

One of the Fed’s key jobs is to stabilise prices , by adjusting interest rates. In fact interest rate manipulation is one of the few remaining effective tools left in its financial tool kit. Higher cost of money however nominally brings with it inflationary pressures that could compound and set of an inflationary spiral. The chances of that however are remote given the record low levels of current inflationary pressure.

Given the likelihood of three planned modest rate rises during 2017, the chances of an inflationary spike is remote however, for the remainder of Federal Reserve Board Chair Janet Yellen’s term. In 2018, her position will be up for renewal, raising the possibility that she might be replaced by a Fed Chairman less receptive to interest rate hikes, particularly if the Trump administration proves to be more interested in  sustaining growth. For the time being, the Trump economic policy path to higher spending, higher inflation and higher rates resulting in a stronger dollar appears to be set.

The interest rate gap between the United States and other major currencies like Japan and the eurozone, both of which have negative interest rates and are deep in bond purchasing, is noteworthy. Such Interest Rate divergence among the world’s major central banks is historically rare, and as the disparity grows, it will boost the gains to be made by borrowing in the lower-rate countries and lending in the higher-rate ones, such as the US, especially if the US economy ‘takes off’.

Such flows of capital among the world’s major centers can be destabilising to weaker economies as was shown with the EU after the recent US Fed rate hike.  The Bank of Japan in particular stepped back from its  quantitative easing and appears now set on a  bond-buying program.

The European Central Bank has reduced its rate of bond purchases, sen as an attempt to reduce the divergence effect ahead of further U.S. rate hikes in an effort to keep the gap under control. The ECB will likely fail.

That said, each central bank also had other reasons for its strategy shift, from the dwindling supply of bonds available for purchase by the Japanese bank to the overall improvement in global economic circumstances and increasing signs of general inflation as commodity prices have stabilized.

In fact, the improving global economic climate has allowed the market to largely ride out developments that at the beginning of 2016 seemed to be filling it with panic. Last December’s U.S. rate hike made China’s yuan look overvalued, especially following the move in 2015 by the People’s Bank of China to break its currency’s dollar peg. The resulting rapid increase in capital outflows prompted the Chinese central bank to spend $100 billion a month in foreign exchange reserves to staunch the bleeding. With under $3 trillion left in China’s reserves and with $2.4 trillion ‘ringfenced’ to underwrite  China’s $16 trillion in loans, the Chinese economy is fast running out of financial defences. Especially so with the prospects of strategic instability in the South China Sea, complicating China’s economic options.

In the wake of Italy’s failed constitutional referendum, and with debt repayment scheduling again approaching, with the banks still vulnerable to instability, the economic situation in Southern Europe is fraught. Populist political elections are due across the EU over the next 18 months, adding to the sense of approaching political and fiscal crisis once more. The shock of Brexit could be followed by more ‘falling dominoes’ as the EU looks vulnerable, at a time when the German economic powerhouse looks weak and divided.

With Italy’s banks now at an extremely fragile point, and with China’s $3 trillion in reserves (effectively only $0.6 trillion available) now 25 percent lower than they were in 2014, countries around the world are hoping that another financial storm will not descend. If it does the US will weather the financial maelstrom better than most.