The US dollar has been skyrocketing. It is up against almost all major currencies and is up more than 20% against the euro from the start of 2015. This has put enormous downward pressure on the prices of various commodities (as most commodities are bought and sold in US dollars in the international markets). The US economy has been clearly showing considerable strength for the past many months (especially when looked from the net jobs being added every month in the US). So with the dollar strengthening (especially at a time when other countries are trying to devalue their currencies to fight off disinflation or deflation forces), the question has arisen if the US Federal Reserve should raise the federal funds rate?
Now, there are arguments from many experts saying that the Fed should wait to see considerable inflation (which is running way below Fed’s target of 2%) before the rates are raised. And many argue that the wage growth is still tepid despite strong growth in the number of monthly jobs being added.
I, for one, believe that the federal funds rate should be raised, but not in summer and instead in fall of this year. Below I note some reasons for that:
1. Wage growth is shortly about to arrive. I say this because from the recession of 2008, workers have been denied a pay raise. That lag is now closing. With an improving economy, companies will be more willing to raise the pay that is long overdue for its workers. We are already seeing that in companies like Walmart, TJ Maxx etc.
2. More hiring, even with an assumed slower wage growth, should increase the consumer prices as measured by the consumer price index in the coming months. With winter behind and spring and summer to come, there would only be increased business activity and more hiring in the coming months. With more people having disposable income, this should only increase retail spending thereby giving a boost to the CPI.
3. Oil prices, in my view, have stabilized a bit. There might be one more downfall of oil towards the $40 - $45 range, but that’s it and even that downfall will be short lived. Wit Europe’s QE and other nations’ interest rate cuts, demand for oil should increase to a level where prices may stabilize around $55 - $65 range by summer (and not to mention the eventual reduction in oil output from global players in 2015 due to the low oil prices). This increase in oil price should give inflation a mild boost in the coming months.
4. As dollar becomes stronger, it might add to downward pressure on the oil prices, but data from Europe signal that the euro region is on a growth trajectory. And I believe Europe’s QE should act as a cushion against deflationary forces from that region – though disinflation could be very well be likely in 2015.
5. It is better to increase the federal funds rate in a gradual fashion from near zero rather than to give a jolt to the economy by allowing it to heat up and raising in a more aggressive fashion (I know some banks have been calling for such a measure, but that will play only to the benefit of banks who play the equity markets to make a lot of money. Given the global scenario, such a measure will not work well for the general economy).
6. Leaving interest rates near zero beyond 2015 will likely result in asset bubbles. Depending on where the bubble is, the burst might be disastrous for the general economy.
7. Even if interest rates are raised starting from the fall of 2015, it would still be low – leaving enough rooms for businesses to continue borrowing for their business activities and for individuals to borrow for purposes like housing loans, vehicle loans etc. Remember we are at a near zero interest rate now and it is going to take years of monetary policy normalization (including all the QE money printed in the last few years) before the rates are at a level where we want them to be in the longer run.
Now, I say that the federal funds rate should be increased in fall rather than summer because of a particular statistic that I don’t agree - And that is NAIRU (Non Accelerating Inflation Rate of Unemployment) which the Fed believes is in the 5 – 5.5 range – meaning unemployment below this range is supposed to trigger inflation at a faster rate. Currently the unemployment rate is 5.5% and analysts believe that the number would be close to 5% by summer putting it will within the range where the Fed should act to raise interest rates. But I disagree with that range. Since we are coming out a massive recession, and with the oil sector being hit, and the fact that the unemployment number is not very accurate and generally has potential to be more on the upside, I would wait until the unemployment falls within the 4.5% – 5% range before starting the normalization process. And that would mean fall of 2015.
In the meantime, I expect gold to drop further, Fed to drop the word “patience” in the March meeting, dollar to become even stronger, Germany to grow and oil prices find a floor sooner than later.
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