This Post Market Wrap is presented by KOSEC – Kodari Securities

• Strong wages growth, rising employment and higher energy costs fuelling inflation 
• Likelihood of 2 percent interest rate by end of calendar year 2022
• Consensus is for 3 percent interest rate by end of calendar year 2023
• Announcement widely anticipated and well received by market generally

US Interest Rate Rise  

The U.S. Federal Reserve board decided to raise the Federal Funds Rate by a quarter of a percent overnight to a target range of a quarter to a half percent. The Federal Reserve referred to strong employment growth and elevated inflation levels as the primary reasons for its decision. Reference was also made to the Russian invasion of Ukraine which is creating upward pressure on energy prices.   

The rate rise was widely anticipated by the bond market, which is why long-term bond rates barely moved on the announcement. The bond market has been telling us for months that we have an inflation problem, with long dated bond yields rising steadily in the lead-up to last night’s Federal Reserve announcement. 

The Federal Open Market Committee (FOMC) stated that economic indicators including employment and wages growth reveal that the US economy is strong.  These circumstances, while supporting a rise in economic activity, when accompanied by a tight labour market, call for decisive action on the interest rate front. In the view of FOMC officials, signs of inflation early last year were attributed to supply chain constraints brought about by lockdowns related to the global COVID-19 pandemic. However, their view now is that inflation is more broadly based, and the most appropriate response is higher interest rates.      

Why is the Federal Funds Rate important?

The Federal Funds Rate is the overnight rate at which the Federal Reserve lends to US banks and so is the benchmark rate at which banks lend to and borrow from each other. If this rate rises, US banks pass on this higher interest rate to their customers. This includes consumer and business loans. The ultimate outcome is less borrowing which restrains spending and this reduces inflationary pressures, because the ability to pass on price rises throughout the economy, is diminished.  Once the inflationary pressures ease, interest rates stabilise, enabling the economy to steadily grow at a sustainable rate. This rhythmic pattern is known as the economic cycle.   

Image: File

Market Implications

In its market release accompanying the rate rise, the FOMC stated it intends to continue raising rates so that the Federal Fund Rate reverts to at least the level that prevailed prior the onset of the global pandemic. The target date to achieve this is the end of calendar year 2022. This statement implies that the FOMC plan 6 more rate rises of a quarter of a percent, over the coming 9 months. This will take the Federal Funds Rate to 2 percent.  The bond market appears relaxed at this prospect, because it is widely recognised that the extraordinary decision to cut interest rates to zero at the height of the pandemic was always a temporary measure to deal with a one in a hundred-year event.  

Equity markets around the globe, including Australia, have also responded positively to the FOMC announcement of a sustained period of interest rate rises over the coming 2 years. This was exemplified by a sharp 1.5 percent rise in the Dow Jones Industrial Index and a 2.2 percent rise in the broader S & P 500 Index and a 3.7 percent jump in the technology heavy NASDAQ, as the FOMC decision was released. Australian markets are also higher today, with the ASX200 up 1.05 percent and the broader All Ords Index up 1.16 percent. History shows that equity markets tend to follow the economy, not the interest rate. This has been confirmed by the strong equity markets seen immediately post the FOMC announcement.

What’s Next?

Beyond the 2 percent target interest rate by the end of 2022, market consensus is for a 2.75 to 3 percent interest rate by end of calendar year 2023. Beyond 2023, present market consensus is that rates would not need to be raised above 3 percent. 

This scenario poses little or no threat to the medium-term economic outlook and should support equity and debt markets as well.

This Post Market Wrap is presented by Kodari Securities, written by Michael Kodari, CEO at KOSEC.