All Eyes on US Federal Reserve as Long-awaited Rates Rise Looms

Published: 16th December 2015 07:34 AM  |   Last Updated: 16th December 2015 07:34 AM   |  A+A-

The world's most important central bank is midway through a meeting that could make economic history.

The Federal Reserve's rates have remained unchanged for the seven years since the financial crisis, and it has not had a chance to raise them since the summer of 2006.

But today (Wednesday), the men and women who decide on US monetary policy are expected hike interest rates, as the US economy achieves the final stage of its recovery from the financial crisis.

Who raises rates?

It is up to the Federal Open Market Committee (FOMC) to decide on the timing of the first interest rate rise.

This committee - of up to 12 members - is presently led by Janet Yellen, the Fed's chairman.

The FOMC meets regularly, around every six weeks, and started mulling its December decision yesterday.

After a vote, the decision of the committee will be announced this evening, and Ms Yellen will hold a press conference.

Does everyone think the FOMC will raise rates?

Investors are as close to convinced as they can be. Financial market data shows they believe there is a 78pc chance of a hike being announced.

Money managers have already altered their positions, reflecting their views that a rate rise is all but guaranteed. Various market interest rates shifted upwards in the days ahead of the FOMC's meeting.

If the FOMC does not decide to raise rates, there would likely be carnage in the markets. Higher interest rates have been "priced in" to financial assets. If policymakers did not want to tighten policy, they should have intervened to cool expectations of a hike.

What does a rate rise look like?

The New York Fed will be charged with steering interest rates higher.

Using a combination of market interventions, it will attempt to steer the Federal Funds Rate (FFR) - the average rate at which banks and credit unions lend to each other - into the FOMC's new target range.

The FOMC's target is currently set at 0pc to 0.25pc. This is expected to rise to between 0.25pc and 0.5pc with the FFR settling somewhere in the bottom end of that range.

Why does the Fed think the US is ready for a rate rise?

The central bank has a dual mandate - steering the economy towards low and stable inflation and promoting maximum employment.

Recent jobs growth and strong GDP figures have indicated that the second half of that mandate has been secured.

However, inflation has remained lacklustre. Figures released yesterday showed that prices were on average 0.5pc higher in the year to November.

Fed officials have been waiting for more indications that inflation is on a path towards the central bank's target of 2pc. They now appear confident that this is the case.

How will rate rises affect the US economy?

By raising the FFR, the Fed is able to guide all other interest rates in the economy.

With financial institutions charging each other more to access cash, the cost of credit should rise generally, reducing demand. This should cool economic activity, and prevent the US economy from running too hot, keeping a lid on inflation.

However, some worry that, with inflation still well below target, raising rates poses too great a risk and that it would be better to wait longer for more evidence that price growth has returned.

Will higher US interest rates affect the rest of the world?

It is not just US demand that will be -affected by higher borrowing costs - it's likely global demand will be too.

It could be harder for vulnerable emerging market economies which took on more debt after the crisis to make payments on these loans, sparking defaults. But one rate rise is unlikely to cause collapse. The pace of subsequent increases will dictate the sustainability of these debts.

If the US raises rates, will the UK follow suit?

Central bank watchers expected the Fed will move before the Bank of England, yet the UK could be left waiting until the early months of 2017.

This is in part because the Fed's interest rate tool takes longer to work. US homeowners are more likely to hold fixed-rate mortgages, rather than ones pegged to the FFR. In the UK, the volume of mortgagors with loans dependent on the Bank's interest rates is far higher.


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