US Fed leaves interest rate near 0, raises prospect of March hike
HOUSTON (ICIS)–The Federal Reserve decided on Wednesday to keep interest rates near zero, but raised the prospect that it will likely increase them when it next meets in mid-March.
The Federal Reserve has a dual mandate of keeping inflation under control and promoting maximum employment.
Inflation is well above its target of 2% and the US labour market is strong, according to the Federal Open Market Committee (FOMC), which makes decisions on US monetary policy. When the FOMC last met to consider interest rates in December, it indicated that the labour market still had not reached maximum employment. It said inflation exceeded 2%.
“The committee expects it will soon be appropriate to raise the target range for the federal funds rate,” it said on Wednesday.
Inflation is being fuelled by the reopening of the economy from COVID-19 and supply-and-demand imbalances that were caused by the pandemic, the Fed said.
The Federal Reserve noted that indicators for economic activity and employment continued to strengthen. Job gains have been solid and the unemployment rate has fallen substantially.
The parts of the economy hardest hit by the pandemic have improved in recent months, the Fed said. However, the recent spike in coronavirus cases has hurt those sectors again.
As expected, the Federal Reserve will reduce in February Treasury purchases by $20bn/month to $20bn/month, it said. Purchases of mortgage-backed securities will fall by $10bn/month to $10bn/month.
These purchases should end in early March, the Fed said.
Kevin Swift, ICIS senior economist, said he was perplexed that the Fed was still buying mortgage-backed securities, since the US housing market was so strong. The same goes for the Fed’s continued purchase of Treasurys.
“These should have been tapering a long time ago and reducing the balance sheet,” Swift said. “It’s distorting the market and price discovery is hard given the Fed presence in markets.”
The reduction of bond purchases and the eventual rise in interest rates could strengthen the US dollar.
Crude oil is bought and sold in dollars. As a result, oil prices tend to fall when the dollar strengthens.
The cost advantage of US petrochemical producers typically falls with oil prices because they rely predominantly on gas-based ethane while petrochemical prices tend to follow crude oil.
Lower oil prices tend to compress US gas-based margins. Conversely, much of the rest of the world relies on oil-based naphtha, so their margins tend to rise when oil prices fall.
A stronger dollar will make imports into the US more competitive. Similarly, US exports would be less competitive.
Outside of the US, weaker local currencies would raise prices for imports, contributing to inflation. Central banks in those countries could respond by raising interest rates, which could slow down economic growth.
Already, central banks in Brazil and Mexico have increased interest rates in an attempt to get inflation back to their targets.
For all countries, higher interest rates could make debt more expensive.
Thumbnail shows US dollars. Image by Shutterstock