Janet Yellen, the Fed chair who has been criticised by Donald Trump, is set to raise rates for third time since financial crash
The US central bank is poised to raise interest rates for only the third time since the financial crash of 2008. With its headquarters just round the corner from the White House, the Federal Reserve and its chair, Janet Yellen, are in Donald Trumps sights.
On the campaign trail Trump said Yellen should be ashamed of the Feds low interest rate policy, and accused the bank of creating a false stock market. Trump has called for higher rates, but Yellen can not take a positive presidential reaction for granted.
The reaction of markets across the world is even less predictable. So what is the likely impact on the US and the global economy?
What is the Fed expected to do?
The Federal Reserve raised the base interest rate by a quarter of a percent in December last year and is expected to follow with a further rate rise on Wednesday. Some analysts expect a quarter-point rise, though most of the betting is now on a half point, pushing the base rate to a range of 1% to 1.25%.
Why will it raise rates?
The US economy has grown for the last 30 quarters and shows no sign of slackening off. Consumer spending is robust and the latest jobs numbers showed employment increasing and unemployment staying low.
Fathom Consulting, an economic forecaster, said spare capacity in the labour market was disappearing fast and it would not be long before wages started to rise rapidly. Wage rises push up demand, and that triggers higher prices.
The Fed has a remit to control inflation, but also to mintain high levels of employment. By raising rates, it will appear to do both.
How will consumers and corporate America react?
The Fed is betting businesses will shrug off the extra cost of borrowing, continue to invest in the US economy and create jobs.
Setting aside concerns about Brexit and a string of potentially destabilising elections on the continent, Fed policymakers have judged that the strength of the economy is enough to override a series of rate rises, possibly taking the base rate to almost 2% by the end of next year.
Consumers have embraced the Trump rhetoric of tax cuts and deregulation to continue spending, undeterred by the prospect of higher mortgage costs.
How will the market react?
Central banks like to signal their intentions, albeit in opaque language, to prevent investors being spooked. This rise was heavily trailed in recent weeks and has been priced in as a certainty by market participants in New York, London and Tokyo though some would be surprised by a half-point rise.
Turbulence could come from the foreign exchange markets if the dollar rises following a slump in the Turkish lira, Indonesian rupiah, Mexican peso or other developing world currency. More importantly, the bond markets could overreact.
Why do the bond markets matter?
Much of the world borrows money in dollars or seeks to lend to the US government and US corporations in dollars. A rise in interest rates would encourage an influx of funds into the US, pushing up the dollar relative to other countries. A rise in the Fed funds rate would also increase the cost of borrowing.
When the Fed first hinted in 2013 that it planned to stop pumping funds into the financial system, the prospect of higher borrowing costs for those holding dollar debts spooked the bond markets. Turkey and Russia were highlighted as countries with corporate sectors that expanded quickly based on heavy borrowing using dollar-denominated bonds. It was clear that much of Turkeys corporate sector could go bust if its interest bill jumped too far or fast.
Such was the strength of the reaction, Ben Bernanke, who at the time chaired the Federal Reserve, abandoned his plan. A similar reaction preceded a rate rise in December 2015, and while markets regained their composure, the extra costs imposed on Turkey and Russia hit their economies hard and arguably shored up the position of their authoritarian leaders.
Is a currency war possible?
Trump has already attacked China for artificially depressing its currency, even when Beijing was doing all it could to close the gap between the yen and the dollar. Now China is letting the yen fall and with interest rate rises in the US pushing up the dollar, the gap will widen, increasing the cost of US exports and reducing import prices.
Trump can only complain about the currency, but he could make good on threats to impose tariffs on Chinese goods, sparking a trade war.
Is there any reason to keep rates on hold?
Annual US GDP growth since the 2008 crash has averaged 2.1%. This might seem like a healthy rate, but it is the slowest recovery from recession since the second world war. Business investment remains low and productivity in the US, as elsewhere in the developed world, is growing sluggishly. To boost borrowing and demand, the Fed needs to keep credit cheap.
But Trump plans to make up for the tightening of monetary policy by cutting taxes and running up a huge budget deficit. He also plans to take his shears to corporate and consumer regulations, unleashing a surge in economic activity.
Bloomberg said investors expect three more rises before the end of the year. Fathom Consulting said there was enough momentum in the economy for rate increases of 25 basis points seven times between now and the end of next year.