Winter is coming (PUN INTENDED). As the world approaches the Christmas season, a storm is brewing in the financial world.

On Dec 16, the Federal Open Market Committee will hold a meeting that may signal the end of cheap credit in the financial world. Unemployment is dropping, wages are rising and the US economy seems to show signs of finally emerging from the historical crisis in 2008. Given the positive local climate, all eyes are on Janet Yellen, chair of the Federal Reserve, as she may potentially raise interest rates to prevent future inflation.

This week, we look at what exactly is the rate hike? Why raise rates now? What is its impact to the world economy? How will Singapore be affected?

What rate are we referring to?

The rate simple refers to the raise of short-term interest rates. in USA. Interest rates in the US have been close to 0 since the outbreak of the global financial crisis in 2008.

Federal Reserve Funds Rate
By pushing the rate to historically low levels, it increased the money supply and also encouraged banks to lend out enthusiastically to raise consumption and investment. The Feds also intervened to lower long-term interest rates through Quantitative Easing(QE), printing artificial liquidity and buying long-term mortgage securities and treasury bonds to lower borrowing costs. It spurred borrowing and lending, a stock market boom and the Fed contends that it was pivotal in pulling the economy out of a depression.

Why raise interest rates now?

The US economy seems to be picking up from the crisis that erupted in 2008. The Feds decision of whether to raise rates are dependent on key factors such as unemployment figures, real GDP growth, inflation and wage rises.

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Unemployment rates have fallen to below 5% which is widely seen as a benchmark of low unemployment thus a reflection of a buoyant economy and efficient usage of resources.

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US average hourly wages have also seen the most significant increase in percentage in the month of October. Conventionally, if you recall the AD-AS model, rising wages are a reflection of a gradual dwindling of spare capacity in the economy as firms experience an unplanned decrease in stocks and bid up factors of production, including labor to keep up with the economic growth. Since one of the central bank main objectives is to ensure sustainable low inflation of around 2%, the rate hike appears to be justified.

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However, the US inflation rates are at historically low levels. Moreover, the Fed’s favoured inflation measure, the index of personal consumption expenditure(PCE), is at near zero and far below the target of 2%.

Nonetheless, markets expect rates to be rising by this December.  “Inflation is not a problem now, but zero rates are a recipe for excess inflation down the road. The longer the wait, the higher the risks. If inflation does break out, the Fed will be forced to tighten aggressively, causing far more damage to the US and global economy than starting now,” says Deutsche Bank’s chief economist David Folkerts-Landau.

Secondly, a rate hike can remove much of the market volatility that has been pre-existing since news of the tapering of QE emerged. Investors have been frightened by the repeated news of possible rate hikes that have fueled massive ‘hot money’ outflow. The gradual rate hikes will signal a reversion back to conventional monetary policy and set the tone for future stability.

Given the evidence put forward, we believe a rate hike is necessary and inevitable. The follow up question one must ask is thus who will catch a frostbite? Who will brace the cold with few worries? Who may potentially end up like Ned Stark?

 

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