Friday 22 July 2016 by Opinion

US interest rates – Pulled in two directions at once

Like Dr Dolittle’s pushmi pullyu, economic conditions are pulling US rates in two directions at once

Locally, economic growth remains on a trajectory we’ve described for some time as “good but not great”.  If they looked at rate decisions without considering the world around them, the US Federal Reserve would be well justified in raising interest rates at least to over 1%pa, i.e. 2 to 3 more increases.  However, the US economy is impacted by the state of the world economy – which faces an increasing array of challenges, now with Brexit and an escalating Italian banking crisis threatening Europe’s stability further. 

Below we outline the factors pulling the Fed in either direction so the reader can form their own view. In summary, we believe that markets have overshot and will likely correct back to around 1.6 to 1.9%pa for the ten year US treasury benchmark. 

The US economy is strengthening – but with the weakness in Europe and Japan and the vulnerability of the Chinese economy, the Fed will not increase rates any faster than it absolutely needs to. It will be wary of the impact that higher rates will have on the USD, and therefore on the competitiveness of its exports.

Pushmi (The case for higher rates)

  • GDP growth edging up to around 2.1% this year
  • Not earth shattering, but GDP rising to this level does not warrant rates remaining at their current low levels.  Most economists expect US GDP to be around 2.5% this year, well above my forecast, but either is supportive of slightly higher personal income growth

  • Inflation
  • US CPI rose by 0.2% in June which, while slightly below expectations, is the fourth consecutive month of steady increases at a 2 to 3%pa pace.  The Fed’s preferred measure of inflation – personal consumption expenditures (PCE) – is running at around 1.7%pa, just below its target rate of 2%pa.  While not yet worthy of a tightening bias, it does provide the Fed with leeway to increase rates from their current lows.
  • Personal Income
  • Disposable incomes are up 3.2% in the past 12 months and have been trending upwards for the past three years, as shown in Figure 1.  In consumer driven economies such as the US and Australia, this is one of the most important drivers of future economic growth and therefore drivers of central banks’ rates decisions.  As a side note, the US increase in personal income is in sharp contrast to the situation in Australia, where incomes are rising at a much slower rate than GDP.

Pullyu (The case for lower rates)

  • US debt
  • Although the US has rebalanced its fiscal accounts, the rising burden of an ageing population – coupled with massive health and social security liabilities – will see its debt to GDP ratio rise to 122% by 2040, up from 102% today. The higher this debt burden, the lower the likelihood of cash rates hikes by the Fed.
  • US manufacturing still in the doldrums
  • Growth in the US manufacturing sector remains weak, largely due to global weakness and the loss of competitiveness resulting from the USD rising in 2015.  Production is down around 0.5% since June 2015 and capacity utilisation has fallen from 78% to 75%, which in turn keeps inflation lower as factories lower prices to increase utilisation.  This will be a major factor in the Fed reservations about raising rates too quickly.  Higher rates make the USD more attractive; more people then buy the USD; the USD then goes up in value; US manufacturing exports then become more expensive in foreign markets; export orders fall, hurting the US economy and weakening the argument for higher rates.

  • Quantitative Easing in Europe and Japan; lower rates in China and the UK
  • The longer that QE continues and the longer that rates are held lower in the rest of the world’s major economies, the more upward pressure is placed on the USD. This in turn will cause the Fed to be wary about raising rates.

  • Stubborn inflation in Europe, Japan and China
  • Related to the above point, inflation is likely to remain stubbornly low in the rest of the world due to weak demand and excess manufacturing capacity.  Europe, Japan and China all have excess capacity in heavy industries, which leads to price competition and therefore deflationary pressures.

  • Trump and political uncertainty
  • The increasing prospect of Donald Trump becoming the next president creates a rising risk of business investment and hiring decisions being deferred. 


While the US economy remains a strong performer relative to the rest of the world, it is not so strong that the US Fed is forced to raise rates.  As long as they have the flexibility, global economic weakness and corresponding downward pressure on other major currencies mean the Fed will remain  very patient – putting up rates once in 2016, once or twice at most in 2017, and remaining below 2%pa for much of the next decade.  Even at these low levels, this is positive for the USD due to the likeliness of lower rates in Europe, Japan and the UK.  Fixed bonds in USD remain attractive at levels above 1.6%pa on the ten year US Treasuries, or lower where the AUD:USD offers good value.