US Economy and Interest Rates

Wednesday, September 24, 2014

With quantitative easing set to end next month, the Fed is on track to start raising interest rates next year, most likely in the June quarter. The anticipation and then reality of this could cause some volatility in shares. However, once it gets underway Fed tightening is likely to be gradual and history tells us that it’s only when rates reach onerous levels that they become a real threat to share markets and ultimately economic growth. Progress towards eventual rate hikes in the US will put further downwards pressure on the $A, which we see falling to around $US0.80.

Introduction

The impending end of the US Federal Reserve’s quantitative easing (QE) program and when it will start to raise interest rates are looming large for investors. Very easy global monetary conditions, led by the Fed, have been a constant for the last six years helping the global recovery since the GFC. But with the US economy on the mend the Fed is edging towards returning monetary policy to more "normal" conditions and this was evident in the Fed’s September meeting. After gradually tapering its QE program all year it’s on track to end next month and attention is now shifting to the first interest rate hike. What will this mean for the US and global economy and for investment markets? This note takes a Q&A approach to the main issues.

How did we get here?

It’s worth putting things in context and recalling how we got to this period of extraordinary easy monetary conditions. At its simplest it was just part of the cycle: growth weakened and so monetary conditions were eased. But the GFC related slump was deeper than normal leaving households and businesses far more cautious. So once interest rates hit zero and it was apparent the recovery was still sub-par, the focus shifted to measures to boost the supply of money. This became known as quantitative easing and involved the Fed printing money and using this to buy government bonds and mortgage backed debt. It helped growth by cutting borrowing costs, injecting cash into the economy, forcing investors

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