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Federal Reserve ponders an interest rate rise

The first rise in US interest rates in almost a decade may be upon us after last week’s US employment data beat expectations.

15-11-12-Yellen-634
Janet Yellen: a hike is now a "live possibility"

The first rise in US interest rates in almost a decade may be upon us. Last week's US employment data beat expectations. The US unemployment rate fell to a new post-crisis low of 5% as 271,000 new jobs were added in October. Meanwhile, average hourly earnings grew at an annual rate of 2.5%, the strongest in six years. Federal Reserve boss Janet Yellen had already warned that a December rate hike was a "live possibility", and with global markets having calmed down jitters over global growth stayed the Fed's hand in September most investors now expect a December rise.

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It's high time the Fed's shilly-shallying stopped, argues Bloomberg.com's Barry Ritholtz. The economy is perfectly capable of coping with higher rates. Thanks to big cash piles, corporate balance sheets are robust. "The consumer has spent the last six years deleveraging." Banks have had ample time to work dud loans off their balance sheets. "I can't fathom why so many people believe that if rates tick up by 25 basis points, civilisation will all but end."

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Besides, the Fed would be wise to give itself scope to cut rates in the next downturn. The bottom line is that rates at zero are "a post-credit-crisis emergency setting, and the emergency is over". Given all this, the absence of immediate inflationary pressure, and potential wobbles for world markets, don't seem convincing reasons to wait. Many analysts, meanwhile, have noted thatUS asset markets are historically overpriced and starting to bubble over after years of near-zero rates.

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In any case, a rate hike may be less important for now than two other factors, says Randall Forsyth in Barron's. According to the Fed's latest survey of senior-loan officers, bank lending standards are tightening. And a higher Fed funds rate would push the dollar higher still, as the Fed is the only central bank contemplating tightening for now. "Tighter lending conditions and a higher dollar may prove more powerful headwinds for the US... and... corporate profits than any small uptick in rates that leaves them at historically low levels."

Will the Bank of England follow suit?

The economic backdrop doesn't seem to have changed much, notes Philip Aldrick, also in The Times, but the Bank has changed its view of the amount of spare capacity (see below) in the economy, which determines how fast GDP can grow without generating inflation. Last week it estimated the amount of slack in the economy at 0.5% of GDP, and it revised its past estimates of this figure higher: in February, slack was apparently 1%, not 0.5% as originally reported, and in August 2014 it was 1.5%, not 1%. "By changing the old numbers, its argument for holding rates stood up to scrutiny."

Yet for how much longer? The Bank says itself that spare capacity should be eliminated in the next year by next November in other words. But if rates don't rise until 2017, inflation could race ahead as spare capacity is eliminated. It's a recipe for "a policy-stoked bubble".

What is the output gap?

The output gap at least in theory is also a key consideration in the government's spending plans. If the output gap is large, it means there is more scope for a return to "normal" growth to help plug the deficit (the gap between annual government spending and the tax take). So it's an important concept. Yet it is also notoriously difficult to measure, which is why the Bank of England has been able to keep revising its estimate of it.

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