This week, most eyes in the financial world will likely be trained on the decision of the Federal Reserve, the US’s central bank, to cut, hold, or raise benchmark interest rates there. Leaders of the Fed are scheduled to meet on 20 and 21 September 2016 to come to a decision on what to do with interest rates. The Fed has kept rates steady since it raised rates by 0.25 percentage points for the first time in nearly a decade last December. While the central bank could cut rates, it is a highly unlikely scenario, so that leaves only…
This week, most eyes in the financial world will likely be trained on the decision of the Federal Reserve, the US’s central bank, to cut, hold, or raise benchmark interest rates there.
Leaders of the Fed are scheduled to meet on 20 and 21 September 2016 to come to a decision on what to do with interest rates. The Fed has kept rates steady since it raised rates by 0.25 percentage points for the first time in nearly a decade last December.
While the central bank could cut rates, it is a highly unlikely scenario, so that leaves only two actions: to hold or raise rates. Two of the Fed’s prominent leaders have each made their case for either holding rates steady or raising rates. I shall take a look at both arguments shortly.
Impact on Singapore
Interest rates in Singapore are closely linked to what happens in the US, so the Fed’s decision could also be of interest to investors here.
Moreover, movement in interest rates can also affect Singapore’s banks, DBS Group Holdings Ltd (SGX: D05), Oversea-Chinese Banking Corp Limited (SGX: O39), and United Overseas Bank Ltd (SGX: U11). To this point, my colleague David Kuo recently wrote:
“Singapore banks that include DBS, UOB, and OCBC make the bulk of their money from the difference in the interest rates that they charge borrowers and the deposit rate that they pay to savers.
When interest rates are low, the margin between borrowing and lending can be wafer-thin. But as interest rates rise, so too does the Net Interest Margin. So, some of the main beneficiaries of a US rate rise could be our local lenders.”
The trio of local banks are important entities in Singapore’s stock market as well, given that they collectively account for nearly one-third of the Straits Times Index (SGX: ^STI).
The Fed’s decision making
The two Fed leaders I mentioned earlier are Fed Chair Janet Yellen and Fed Governor Lael Brainard. Yellen’s the one who has laid out a case for a rate hike while Brainard is in the “hold it steady” camp.
Both Yellen and Brainard are permanent voters on the 10-member Federal Open Market Committee (FOMC), which is the group within the Federal Reserve that makes decisions on interest rates. So, their views on the possible path of interest rates are important.
Yellen on why rates should be raised
In a speech dated 26 August 2016 delivered at the Jackson Hole conference organised by the Federal Reserve Bank of Kansas, Yellen laid out why rates should be raised.
Yellen explained in her speech, titled “The Federal Reserve’s Monetary Policy Toolkit: Past, Present, and Future”, that the US economy has recovered steadily since the Global Financial Crisis erupted in 2008. The unemployment rate in the country has also fallen below 5% but inflation has not reached the Fed’s 2% target due to ‘transitory effects’ from the plunge of oil prices over the past two years.
Yellen also expects the labour market to strengthen and inflation to hit 2%. Most notably, she said:
“Indeed, in light of the continued solid performance of the labor market and our outlook for economic activity and inflation, I believe the case for an increase in the federal funds rate has strengthened in recent months.”
In an important boost to Yellen’s argument, the US Department of Labor announced last week that the US consumer price index had increased by 0.2% in August 2016 on a month-on-month basis and 1.1% on a year-on-year basis.
Brainard on why rates should be held steady
As for Brainard, she noted in a 12 September 2016 speech, “The “New Normal” and What It Means for Monetary Policy”, that inflation has failed to reach its target for 51 months despite the fall in the unemployment rate from 8.2% to 4.9%.
Hence, we cannot assume that lower unemployment would lead to stable inflation of 2%. The Fed has the obligation to both keep inflation stable and unemployment low.
Brainard suggests that it is not sufficient to use unemployment to gauge the strength of the labour market; it is also important to keep track of people who are working part time because they can’t find full time jobs.
She also thinks it is possible that the US may face long-term disinflation (disinflation is the decline in the rate of price inflation) because of the weak labour market and also weak or slower growth in other regions such as Japan, China, and Europe.
We’d soon know if the FOMC’s other members belong to Yellen or Brainard’s camp.
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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Ong Kai Kiat owns shares in DBS Group Holdings.