Federal Reserve Rate Hike and its Implications on the Global Economy

Jonathan Eng

After the release of the Federal Open Market Committee (FOMC) minutes on the 22nd November, there has been a mixture of reactions to the signalling of an increase in the Federal Rate. The minutes reflect a more positive atmosphere in the US economy; with a strengthening labour market and a gradual increase in household spending and business investment. A streak of hurricanes drove up gasoline prices in September, fuelling short-term inflation. However, little has been done to impact medium- to long-term growth, with expected longer-term inflation targets remaining unaffected.

The FOMC expect that such economic activity will prevail, which warrants a gradual increase in the federal fund rate—henceforth, Rate—but will remain at levels lower than what is expected to prevail in the long-run. This sentiment has had several repercussions in the dollar, gold, Treasury Bonds and Foreign Exchange markets.

Theoretically, any rise in the Rate would result in the appreciation of the dollar as there becomes fewer dollars in the market due to a higher Rate. However, the dollar currently remains at one its weakest levels since mid-October and has fallen 0.9%. This is mainly due to the fact that markets have already priced in the potential hike in December into existing prices. However, beyond December 2017, the minutes appear vague and uncertain; compounding this with a flattening of US yield curves which only points to short-term Rate hikes and the result is a defensive dollar to protect domestic interests.

This uncertainty in the medium-to-long run in monetary policy has also been reflected in the price of gold and Treasury bonds. Gold went up 1% and traded at 0.8% higher and yield on 10-year Treasuries dipped slightly after the release of the FOMC minutes. Gold is generally perceived as a ‘safe-haven commodity’ whilst US treasury bonds are secure investments with sure-returns; essentially a ‘safe-haven investment’. The fact that gold and Treasury prices have risen reflect cautious investor confidence in the market. This attitude in investor confidence will result in 1 of 2 outcomes; either the price of gold continues to rise while treasury yields fall, or an influx of FDI will go towards China.

Attitudes across the Pacific contrast the defensive reaction in the West. The Yen and Australian dollar went up 0.3% against the dollar while the Dollar Index, which tracks the dollar against a basket of global peers, was down 0.2% in Asia. The index had moved down as much as 0.8% on the day, ahead of the release of the minutes. A weaker dollar remains favourable for China, which pegs the yuan against the dollar. Given China’s current appetite for exports and reputation for cheap labour, a lower dollar will relieve pressures on Chinese exports to the West for the time being.

Despite uncertainty in the medium-to-long term, what is clear in the short run is that the US economy is showing signs of being on track to recovery, with historic quantitative easing being rolled back and Rate hikes being back on the discussion table. What is less certain is how rates will change in the long run, as US inflation is expected to fail to meet its 2% target. How markets will price the dollar and yields accordingly is also undecided. For the time being however, China would almost certainly welcome a weaker dollar, as it continues to leverage cheap exports and extensive FDI to fuel its economic growth.

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