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Will Interest Rates Rise In The US In June 2016?

Initial claims for unemployment benefits, a proxy for layoffs, fell to a 42-year low in the week ended April 16; according to official data, initial claims for unemployment benefits fell by 6000 to a seasonally adjusted 247,000 in the week ended April 2016

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Economic data on consumer confidence, retail sales, consumer spending (which accounts for more than two-thirds of US GDP and is the locomotive of the US economy), auto sales, industri-al output and capacity utilization, overall construction spending, durable goods orders (particular-ly core capital goods (non-defense, ex-aircraft) orders), manufacturing activity and trade seem to suggest that the US economy slowed down sharply in the the first quarter of 2016 (official GDP figures are yet awaited), when compared to the previous quarter - where it grew by a subdued annualized rate of 1.4 per cent - according to official data.

Essentially, in the first quarter, financial market volatility, concerns about weaker global econom-ic outlook (particularly about Chinese economic slowdown) and weak US corporate earnings, fall in stock prices and weather related problems weighed heavily on business sentiment (at a time when business investment had earlier fallen by 2.1 per cent in the fourth quarter - according to official data) and consumer spending (which had earlier grown by a solid 3.1 per cent in 2015- according to of-ficial data - and averaged a highly respectable growth rate of 3.02 per cent between 2013Q4 and 2015Q4), as these factors engendered more uncertainty and nervousness about US short-term economic outlook at a time of tepid external demand.

After conducting a holistic analysis of the US and global economy (particularly the Chinese economy), I expect the marked growth deceleration in the first quarter in the US to be temporary - with economic momentum gaining traction gradually in the second and remaining quarters of 2016 (though annual growth is likely to be slower in 2016 (probably 2.1 per cent -2.3 per cent), when compared to 2015 (2.4 per cent)) as a result of weaker business investment and net exports and slightly lower con-sumer spending, when compared to the previous year) - and, contrary to many financial market participants and economists, I believe that there is a high probability of the US raising interest rates (by 25 bps) for the first time in June 2016 (due to six reasons enumerated below), despite a slump in business investment and corporate profits in the US, and gargantuan debt levels in Chi-na (particularly non-financial private sector debt in China - which according to Bank of Interna-tional Settlements data, was a staggering 205.2 per cent of GDP as of the third quarter of 2015) - which have serious medium and long-term (rather than short-term) implications for the Chinese econo-my.

Six Reasons:
- Core Inflation (Core CPI): which excludes food and energy and is a better gauge of underly-ing price pressures than headline inflation (CPI), has been ticking up in early 2016 (even though headline inflation (CPI) slowed for the second consecutive month in March) - suggest-ing a pick up in inflationary pressures as a result of sufficient aggregate demand; according to official data, core inflation year-on-year rose more than expected by 2.2 per cent and 2.3 per cent in January and February respectively. Further, even though core inflation rose at a slightly lower rate of 2.2 per cent in March, yet it remained above 2 per cent for the fifth consecutive month - with core services inflation persistently increasing over the past several months and rising by 3 per cent year-on-year in March - though slightly slower than 3.1 per cent in February. I expect core inflation to pick up further this year as aggregate demand strengthens. Moreover, a rise in April and May in the same is likely to prompt the Federal Reserve to raise interest rates for the first time in June this year. Core inflation, according to official data rose by 2.1 per cent in 2015 and I expect it to be moderately higher in 2016.

- With reference to headline inflation, strengthening labour market, continuing wage gains, probability of pick up in consumer demand, strengthening of the housing market and fading of drags on inflation from US dollar appreciation and sharp fall in oil prices in the past (which have held down headline inflation) should all result in a gradual rise in inflation in coming months - particularly towards the second half of 2016 - leading to headline inflation going up closer to Federal Reserve's target of 2 per cent. Further, oil prices are currently hovering at around US$43 (quite a recovery from a low of US$27 on February 11th, 2016) as concerns about a global oil supply glut have eased due to declining oil production in non-OPEC coun-tries such as the US - which in turn should also put some upward pressure on inflation in the coming months.

- Labour Market: strong job growth and reduction of labour market slack are continuing; ac-cording to official data, non-farm payrolls increased by a solid 215,000 in March, though low-er than the upwardly revised 245,000 in February (and 168,000 in January), and rose by a ro-bust 2.8 million over the year. The unemployment rate inched up to 5 per cent in March, from 4.9 per cent in February, as a result of increase in the labour force participation rate which, according to offi-cial data, rose to 63 per cent in March (a two-year high), from 62.9 per cent in February and 62.7 per cent in Janu-ary - indicating that increase in employment is now diminishing labour market slack.

- A key point to note is that hiring in the all important services sector (which generates more than 80 per cent of all employment (i.e job creation) in the US and accounts for more than 80 per cent of US GDP) continued to be solid in March too. Further, wage growth picked up in March; ac-cording to official data, average hourly earnings rose 2.3 per cent year-on-year in March, after having grown at a slower pace (2.2 per cent) in February, from 2.5 per cent in January and 2.6 per cent in December. Go-ing forward, I expect the solid job growth to continue in the second quarter as well as moder-ately stronger wage growth this year - due to reduction in labour market slack and further low-ering of the unemployment rate - putting upward pressure on inflation.

- Initial claims for unemployment benefits, a proxy for layoffs, fell to a 42-year low in the week ended April 16; according to official data, initial claims for unemployment benefits fell by 6000 to a seasonally adjusted 247,000 in the week ended April 2016 - suggesting that slow-down in growth in the first quarter was temporary.

- Retail Sales and Overall Consumer Spending: I expect tepid growth in retail sales and con-sumer spending (please refer to official data below) in the first quarter (despite resilience of re-al income growth) to have been temporary as global headwinds have somewhat abated, finan-cial conditions in the US have eased and there has been reversal of recent equity market losses (along with rising stock markets and reduction of financial market volatility) - all of which are likely to lead to restoration of consumer confidence in the second quarter (which in turn should lead to a moderate pick up in retail sales and overall consumer spending in the second quarter and more rapid rise in the same particularly later this year (resulting in strengthening of economic momentum and upward pressure on inflation).

- In addition, quite a few factors are likely to provide support to retail sales and overall consum-er spending in the second quarter and remaining quarters of this year; continuation of strong employment growth (higher than 200,000 per month) and reduction of labour market slack, likelihood of moderately higher wage growth in coming months, continued income gains, ris-ing house prices (supported by low mortgage rates, tighter supply and improving labour mar-ket) - providing positive support to household wealth - accumulated savings, low interest rates and inflation, lower household debt-to-income ratio and gradual easing of credit.

- Though, retail sales, according to official data, fell 0.3 per cent month-on-month in March, after reg-istering flat growth in February and dropping in January, yet on a year-on-year basis, it contin-ued to grow (albeit tepidly) by 1.7 per cent in March (weakest growth since November), when com-pared to 3 per cent and 3.1 per cent in February and January respectively. Further, overall consumer spend-ing (which accounts for more than two-thirds of US GDP) also witnessed lackluster growth; according to official data, consumer spending in real terms grew by only 0.2 per cent month-on-month in February, after being flat in January (official figures for March are yet awaited) and year-on-year it grew by 2.8 per cent and 2.6 per cent in February and January respectively (official figures for March are yet awaited). Real disposable income has been fairly resilient and grew, accord-ing to official data by 2.7 per cent and 2.6 per cent year-on-year in February and January respectively.

- Service Sector Activity: After weakening global economic outlook and financial market tur-moil led to a cooling of services sector activity in February, it picked up again in March. Since the services sector accounts for more than 80 per cent of US GDP (i.e it is the dominant sector in the US), it points towards domestic economy gaining momentum after a highly sluggish first quar-ter and that growth is likely to be stronger in the second quarter. Further, acceleration in ser-vices sector activity in March points towards this dominant sector offsetting the drag on growth from weak manufacturing activity (this sector accounts for only around 12 per cent of US GDP) and also indicates fairly resilient domestic demand and economy.

- Turning to data, the ISM Non-Manufacturing Index (which tracks the all important services sector) rose more than expected to 54.5 in March (the 74th consecutive month of expansion of services sector activity - according to this survey), from 53.4 in February. The improvement in services sector activity in March, from February, comes as a relief. This is because services sec-tor activity had decelerated slightly in February, when compared to January (the ISM reading for January was 53.5). Further, the key point to note is that the Business Activity Index, New Orders Index, Employment Index and New Export Orders Index of the ISM non-manufacturing survey increased in March, when compared to February, and were all in expan-sionary territory. The increase in new exports orders in March was particularly strong (indicat-ing easing of weakness in external demand) and 12 out of 18 non-manufacturing industries expanded in this (March) month - according to this survey. All this points towards more opti-mism about sales and output growth in this sector in the second quarter and coming months as domestic demand is likely to remain supportive.

- Housing Market Activity: despite softer than expected housing market activity in the first quarter (particularly in March, where, according to official data, housing starts fell unexpected-ly by 8.8 per cent month-on-month and building permits (which hit a one year low) fell 7.7 per cent month-on-month), I expect a rebound in housing market activity in the second quarter and the coming months of this year (which in turn will provide support to aggregate demand and growth), giv-en the favorable outlook for the housing market and related activity - as a result of strong em-ployment growth (which is leading to improvement in household formation rate) and likeli-hood of further tightening of the labour market, strong income growth and prospects of mod-erately higher wage growth in the coming months, rise in household savings rate, lower house-hold debt-to-income ratio (i.e. better household balance sheets), demand for homes (which re-mains strong as indicated by more than expected rise in existing home sales in March - that in turn will positively impact economic growth in the second quarter and should also help the economy to firmly put behind the sharp deceleration in economic activity in the first quarter), low inventories, housing supply being a constraint, easing bank lending standards, reduced home price inflation and expectations of continuation of moderate hike in house prices, and continuation of historically low mortgage rates (given the prospects of a very gradual hike in interest rates by the Federal Reserve this year) - which are currently well below 4 per cent.

- External Conditions: financial conditions in the US, which had deteriorated markedly at the inception of this year, have recently started to demonstrate improvement - with near record US equity prices and the stock market having largely recovered its losses, a weaker dollar and eas-ing of credit spreads (which are currently significantly below their recent highs). Most im-portantly, global financial market volatility has diminished considerably, when compared to earlier this year - a major reason being significant lowering of concerns about a hard landing of the Chinese economy or that this economy will slow down more rapidly than expected - lead-ing to marked depreciation of the yuan, competitive currency devaluations or currency wars across the globe (particularly - emerging economy currencies), wave of deflation and sharp de-celeration in economic activity in the economies of its major trading partners (such as Japan, South Korea, Germany, Malaysia, Taiwan, Singapore), commodity exporting countries (such as Australia, Canada etc.) and the entire Asia-Pacific region - due to trade and supply chain linkages with China.

- Essentially, Chinese policy makers have given significant stimulus to the Chinese economy (to prop up growth in the short-term), which includes increased fiscal spending on infrastructure (that has been going on since mid-2015) and reduction in taxes for private sector firms along with substantial stimulus to the real estate sector (for example, easing of credit regulations for house purchase, lowering of down payment requirements for house purchase and reduced tax-es) and extended monetary stimulus (six interest rate reductions since November 2014 (to 4.35 per cent currently), reductions in required reserve ratios (to 17 per cent currently) and providing of more incentives to enhance bank lending). Further, resilience of consumer spending and con-tinued expansion of the services sector (which now accounts for just over half of Chinese GDP) are also providing support to growth and preventing a sharp economic downturn.

- As a result of the aforesaid factors, the Chinese economy grew at an annual rate of 6.7 per cent in the first quarter of 2016 (according to official data), slightly lower than 6.8 per cent in the fourth quarter i.e. loosing some growth momentum, but not significantly. More importantly, latest economic data (for March) on key economic indicators such as industrial production, fixed in-vestment, trade, real estate investment, manufacturing and services sector PMI's and retail sales point towards stabilization of economic activity.

- Going forward, I expect growth to decelerate further in the remaining quarters of 2016, how-ever moderately (due to reasons stated above and expectations of more fiscal and monetary stimulus in the months to come), rather than sharply. Consequently, I expect the yuan to de-preciate by a modest 5-7 per cent this year, rather than steeply, and capital outflows from China to moderate in the short term - after unprecedented outflows were witnessed until January 2016.

- Next, the Chinese government plans to raise the fiscal deficit target to 3 per cent of GDP, from 2.3 per cent of GDP in 2015 and go in for more rapid money supply growth (the government is targeting M2 (measure of money supply) growth of 13 per cent in 2016, compared to the 12 per cent target in 2015) and credit growth this year, in order to achieve the officially targeted GDP growth rate (6.5-7 per cent) for 2016 and avert a sharp economic slowdown at a time when structural reforms are be-ing pursued.

To conclude, I envisage strengthening of growth momentum and core inflation picking up fur-ther in the second quarter in the US along with slight deceleration in Chinese economic growth in the same quarter (due to reasons stated above), when compared to the previous quarter (i.e. there is going to be no collapsing of growth in China). Further, oil prices, due to easing global supply glut, are unlikely to plunge or fall sharply from current levels and abundant liquidity and a weak-er dollar are likely to to remain supportive of US equities, bonds and emerging market assets in the second quarter. Moreover, financial conditions in the US should continue to remain easy in the second quarter. All these factors together should result in relative calming down or further receding of global financial market volatility.

Taking account of all that has been stated above, in my estimation, there seems to be a high probability that the Federal Reserve will raise interest rates (Fed Funds Rate) very gradually for the first time this year in June (by 25 bps).

Disclaimer: The views expressed in the article above are those of the authors' and do not necessarily represent or reflect the views of this publishing house. Unless otherwise noted, the author is writing in his/her personal capacity. They are not intended and should not be thought to represent official ideas, attitudes, or policies of any agency or institution.


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Sher Mehta

The author is Director of Macroeconomic Research and Econometrics, Virtuoso Economics

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