COLUMN: We have lift off as US Fed raises interest rates

THIS week, the US Federal Open Market Committee (FOMC) announced a 25 basis point increase in their key policy interest rate (the Federal Funds rate), from a range of 0 per cent to 0.25 per cent, to a range of 0.25 per cent to 0.5 per cent.

This is the first rate hike since June 2006 - a long enough period between drinks to argue that a decent number of today's financial market participants will have never seen a US rate hike before.

No one should have been surprised by this - there has arguably never been a more widely telegraphed start
to a monetary policy tightening cycle.

In the statement accompanying the decision, the FOMC emphasised two things that should be taken positively by share and bond markets.

Sunsuper chief economist Brian Parker
Sunsuper chief economist Brian Parker Contributed

Firstly, the reason the FOMC has been able to take this step is that the US economy is in good shape: the labour market has largely healed, the unemployment rate is back to pre-GFC levels, and the economy continues to generate decent jobs growth.

Both household spending and business investment have been expanding at healthy rates. In short, the US economy no longer needs the kind of extraordinary support from monetary policy that it has had since early 2009.

Secondly, that the outlook for inflation is benign enough to allow the FOMC to raise interest rates only gradually from here, although the members of the FOMC are still anticipating having to raise interest rates further over the coming year than financial markets are currently anticipating.

The FOMC members did not revise their projections for the federal funds rate lower, which was something of a surprise.

Whether interest rates follow the path projected by the FOMC or that currently priced by financial markets, it still means that monetary policy is likely to remain easy for some time to come.

And it's not just that interest rates are not likely to rise terribly far.

The Federal Reserve hasn't begun to reverse the massive asset purchases it conducted under its quantitative easing (QE) program.

In October 2014 they brought their QE program to an end (i.e. they stopped their monthly asset purchases) but they are still reinvesting the proceeds of any bonds on their balance sheet when they
mature, and it is likely to be some time before they start selling assets back to the market.

In their statement the FOMC anticipates continuing to rollover those assets until normalisation of the level of the federal funds rate is well under way.

It's also important to look at the FOMC's move in a global context. While the Fed is starting to slowly tighten monetary policy, the world's other two major central banks - the European Central Bank (ECB) and the Bank of Japan are doing nothing of the sort.

The Bank of Japan is maintaining its aggressive QE program, and the ECB modestly extended their program and reduced official interest rates earlier this month.

Monetary conditions globally are still very supportive of both the global economy and share markets even after the FOMC's move.

That's good news, but it's also important to remember that financial markets tend to move in advance of the economy: weaker share markets can be an early warning sign of weaker economic growth or recession, and a sell-off in credit markets (the market for nongovernment bonds) such as we've seen in recent months, can be a sign of corporate balance sheets coming under stress.

While it seems too early in either the interest rate cycle or the economic cycle to be overly concerned about future prospects, the investment environment remains very volatile.

This is an environment where managing risk - being as well diversified as possible - rather than chasing returns is critical.

Brian Parker is chief economist with Sunsuper

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