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Volatility will follow first Fed rate rise since 2006, economist warns

17 Dec 2015

London Business School economist predicts volatile New Year

LindaYueh

The first Federal Reserve rate rise in nearly a decade will make for a volatile New Year as economies, companies and households adjust to the end of an era of zero interest rates, an economist has warned.

Future rate hikes are expected to be gradual and below 1.5% for 2016 according to the US central bank’s forecasts. But Linda Yueh, Adjunct Professor of Economics, London Business School, warns the move towards normalising interest rates will be followed by a period of volatility.

Dr Yueh says: “This is widely expected, so it shouldn’t be a shock to the global economy. But that doesn’t mean there won’t be volatility given that the US central bank sets the cost of borrowing for the rest of the world.

“Emerging markets will be watching closely as their currencies are largely pegged to the US dollar. With China, Europe, and Japan respectively cutting rates and undertaking quantitative easing, the world economy faces a divergence in global monetary policy that is hard to manage in their economies even if the path of Fed rate hikes is smooth and slow. Their currencies will be pulled in two directions: moving upward with the US dollar and trying to stay competitive with the RMB/euro/yen. This tricky course has really begun for these markets.”

The impact though is not limited to currencies and exchange rates, as Dr Yueh explains:

“The other signal that markets will take from an increase in interest rates is that the cost of borrowing is rising, so investors will want to take less risk. The Institute of International Finance (IIF) expects that a net $500 billion has left emerging markets in 2015, which would mark the first net annual capital outflow in decades, since 1988”. 

The adjustment to a world where interest rates are no longer about zero will be sizable for major economies too, Yueh says.

“The cost of money has been zero for seven years and it has been nearly a decade since anyone has had to adjust to a rate increase by the Fed which sets the base cost for global markets. 

“The Bank of England may not follow the Fed straightaway in raising rates, but with the economy in recovery mode and unemployment dropping to 5.2%, which is close to the long-term trend rate, the UK will follow in due course. “

The Bank of England has warned that about one-third of households will have to cut their spending or borrow more if interest rates rise to just 2%. That’s about half the pre-crisis interest rate. 

As the world’s largest economy, the US getting back to normal is a welcome development for the global economy. But despite the rises being small and slow, the path, it seems, could be less than smooth.