The markets should chill: US Fed's much ballyhooed rate hike may well be its last

Will she, won’t she? Will US Federal Reserve Chairman Janet Yellen raise interest rates for the first time in almost a decade, or will she chicken out once more?

Here’s my guess: she will raise the rate 0.25 percent, but then balance it by saying the next one will not be coming for some time. With US unemployment rates falling to 5.1 percent – the lowest since 2008 – she actually has no reason to delay a rate hike.

The reason why Yellen will probably take the plunge this time is simple: having threatened to raise rates for more than a year after ending quantitative easing, the Fed’s credibility will be at stake if she again waffles. So the chances are she will raise rates on 17 September, when the Fed meets, and then hold off further hikes for a prolonged period.

 The markets should chill: US Feds much ballyhooed rate hike may well be its last

Federal Reserve Chair Janet Yellen. Reuters

The Fed will not be keen to take further risks by opting for more aggressive rate hikes because US the economic recovery is far from robust. The International Monetary Fund (IMF), in its June forecast, in fact advised the US Fed to delay its rate hikes till 2016 because global growth was still slowing.

In its last report on US economic prospects, the IMF reduced its growth forecast from 3.1 percent to 2.5 percent this year, and it is likely to scale this down further in its next estimate due in October.

A rate hike in this context will thus be only a token effort by the US Fed, as the risks outweigh the benefits.

Three factors will weigh with the Fed.

First, any open-ended commitment to keep raising rates purely on the basis of falling unemployment figures will result in the dollar appreciating against the euro, yen and yuan, making US exports less competitive and imports more attractive. This cannot but reduce domestic manufacturing and services growth. The US cannot afford an endless rise in the dollar.

Second, the sharp drop in global oil prices, a positive signal for the US when it was a net importer of oil, is now a negative. A large chunk of the recent US revival came from success in boosting cheap natural gas and shale oil production, which reduced its dependence on West Asian oil. But with Opec defending market share despite price declines, American shale oil production is rapidly becoming uneconomic at the margin. This is forcing cutbacks in investment and will reduce growth in its energy sector.

Third, a costlier dollar will slow down global growth further as other countries will try to prevent capital outflows by maintaining interest rates at higher levels than what is warranted by domestic inflation trends. For example, Raghuram Rajan is cautious on cutting rates despite falling inflation because he wants to see what happens to US rates. All emerging market central banks will be fretting about capital outflows in the event the Fed promises to keep raising rates. This factor will ensure that Yellen will not go beyond tokenism on rate hike.

So here’s what could happen: one rate hike, and nothing after that for at least the next six months. Yellen’s rate hike may be the last for this year.

For India, it means it will be business as usual after a short period of forex market volatility. The stock markets should relax.

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Updated Date: Sep 16, 2015 08:00:03 IST