After two days of testimony before Congress and the U.S. House of Representatives Financial Services Committee, Fed Chair Janet Yellen seems to have convinced investors there will be further rate hikes this year.
Image 1: Fed comments get different reactions – Bloomberg
Her tone was more hawkish than during previous hearings, which seems to have gone down well with traders. In the past, expectations of even a single rate hike were enough to depress the markets. Now, the idea of a rapid normalization of U.S. monetary policy has the opposite effect, with markets recording their biggest rally in three years.
There is now an estimated 42% chance that the Fed will increase interest rates to the 0.75%-1% range at its meeting on March 14-15, compared with a probability of only 24% on February 6. These percentages are calculated according to the price evolution of Federal Funds futures and the comments of various Fed members.
In her testimony, Janet Yellen emphasised the fact the Fed would increase its rates slowly and gradually. She stressed, however, it would be “unwise” to wait too long. She also highlighted uncertainties surrounding future U.S. policy:
“I would also hope that fiscal policy changes will be consistent with putting U.S. fiscal accounts on a sustainable trajectory.”
Yellen’s testimony is only one reason for the increased probability of coming rate hikes. Inflation figures for January were higher than expected, with the Consumer Price Index (CPI) reaching 0.6%, the largest rise since February 2015. The annual increase from January 2015 to January 2016 was around 2.5%, the strongest since March 2012.
Image 2: Inflation CPI January – BLS
The CPI is not the Fed’s first port of call when determining price trends. The Personal Consumer Expenditure Index (PCE) is considered a more accurate snapshot of inflation. The two indices, however, are closely related, and an increase in the CPI number means that the PCE index will also be higher.
One of the Fed’s key objectives is maintaining price stability. A PCE figure of 2% is considered optimal in terms of delivering this, and for achieving the other part of its mandate: full employment.
Image 3: Dollar Index – Daily
The U.S. dollar is likely to rise at the prospect of a tightening of monetary policy. As discussed in our previous analysis: “all decisions made by a central bank influence the cost and availability of that economy’s monetary holdings, directly impacting currency supply and demand in the foreign exchange market.
When a country’s interest rate rises, this attracts foreign investors, as demand for the national currency increases relative to other currencies. Higher interest rates also increase borrowing costs, reducing the amount of money in the markets, further boosting the value of the relevant currency.”
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