17 Dec 2015 09:17

An unusually longed-for rate hike

As expected, the United States Federal Reserve (Fed) decided on Wednesday, December 16 to raise the target range for its key interest rate by a quarter percentage point to 0.25-0.50 per cent. One main reason is a gradually tighter labour market situation in the US economy, causing the Fed to believe in rising inflation. The Fed has maintained a “zero interest rate” for seven years and has also purchased a huge USD 4.5 trillion worth of debt securities, among other things in order to support US growth and employment.

“This is a welcome and positive decision. It confirms that the US economy and financial system are on the right track after a historically long uphill battle that began in the Great Recession of 2008-2009,” says SEB's Chief Economist Robert Bergqvist. “The US came close to hiking interest rates earlier this autumn, but renewed uncertainty about China and depressed stock markets persuaded the Fed to hold off.”

The Fed’s key interest rate and the US dollar (USD) are of vital global importance and are at the epicentre of financial markets. In recent years, USD-denominated debts of emerging market (EM) economies have doubled to more than USD 3 trillion. EM countries have thus become more dependent on the direction of US monetary policy. Higher interest rates and a stronger dollar pose challenges to a number of countries that are already struggling with falling commodity prices – especially vulnerable are those countries that have pegged their own currencies more or less tightly to the US dollar.

“The step that the Fed has now taken means that it has very slightly lifted its foot, but it is still pushing down hard on the monetary gas pedal,” says Bergqvist.

“In addition, the Fed’s fixed income portfolio, at USD 4.5 trillion, translates into a key rate perhaps 2 percentage points lower. The Fed's action thus hardly poses any threat either to economic growth or the stock market. Because of rising but still low inflation, the risk of undesired global secondary effects and an interest-sensitive economy, the process of normalising US interest rates may move slowly,” says Bergqvist. “We expect the next Fed rate hike to occur in June. By the end of next year the federal funds rate will be 1.25 per cent, and at the end of 2017 it will be 2.00 per cent. This is an interest rate path that is a bit tougher than the market’s average forecast, but still clearly cautious.”

Due to Sweden’s heavy dependence on exports – 50 per cent of its economy is connected to foreign trade – we need the US to be a strong, prosperous economy that can help sustain global growth.

“The Fed’s rate hike will help ensure US dollar strength and thus a continued weak krona, which will benefit Swedish exporters,” says Bergqvist. “It also confirms the strength and increased stability of the US economy, which is good for Sweden. Of course there is also a risk that US interest rate hikes will generate uncertainty in stock markets and thus also push down Swedish equities, but we must not forget that the Fed will have its foot on the monetary gas pedal for several more years.”

Earlier this week, Sweden’s Riksbank decided to leave its repo rate unchanged at -0.35 per cent, to continue maintaining a relatively high probability of a further 10 basis point rate cut in February and to keep buying government bonds totalling SEK 200 billion.

“Like all the rest of us, the Riksbank had already assumed that the US would hike its key rate, so the outlook for Swedish monetary policy will not change. But we also expect Sweden to begin a cautious normalisation process during the latter part of 2016 and to phase out today's negative interest rate. As 2015 draws to a close, Sweden is enjoying an economic boom, has an undervalued krona and is experiencing a powerful dose of stimulus from fiscal policy, due to the refugee crisis. Because of increased resource utilisation, the Riksbank’s key interest rate will slowly follow the Fed’s cautious rate hikes,” Bergqvist concludes.