Annualised core PCE came in at 1.7% vs. 1.2% consensus, this is following CPI data of 2.2% annualised a week earlier. This puts the Fed in a tough situation. Domestic inflation is rising, indicating a rate rise, but the Fed is particularly cautious about the global economy. Policy divergence, the Fed raising rates whilst other countries cut rates, causes global imbalances that are potentially destabilising.
What will happen if the Fed raises rates?
This might signal to the markets that the Fed is entering a tightening cycle, raising rates at constant pace, to slowdown the economy and bring down inflation. With the current inflation figures the expectations of at least one rate rise this year jumped from 25% to above 40% and whilst a rate rise is not expected in March, it is likely to come through over the next few months. The Fed is cautious because rate rises increase the yield of assets in the USA, causing the demand for dollar-denominated assets and currency to appreciate. A higher dollar affects the entire world economy.
- Commodities are priced in dollars, meaning countries will receive less dollars for the same amount of commodity (ceteris paribus), these countries tend to be developing, emerging, countries.
- These countries then get hit by another channel; a stronger dollar increases the value of their debt, which is denominated in dollars.
- Therefore they end up with reduced income, and have to pay off more expensive debt.
This wouldn’t be a problem, if it wasn’t for the fact that developing markets account for 40% of global demand. With China slowing down and oil prices falling, the Fed is cautious about making decisions that would harm the global economy.
Why should they care about the world economy?
If the domestic economy is overheating and inflation is rising towards, and soon above, the target rate then surely they should be raising rates? However the USA is integrated into the globalised economy, therefore if they prematurely raise rates they might damage the global economy and potentially put the USA into a worse position if a weakened global economy slows down their economy.
These are the indicators to keep an eye on:
Wage growth 2.5%
Employment is strong and inflation rates are rising towards the 2% targets, however wage growth is still weak and doesn’t show any immediate signs of exponential growth. Nonfarm payrolls this coming Friday will be important.
There will be a rate rise this year, but it will be following with a pragmatic speech by the Fed and reassurance that they are not following a tightening cycle. As for the global economy, maybe it is time we got used to slower growth.