The backdrop
With stock markets wobbling, inflation on the floor and question marks hanging large over China, you might well ask why the Fed was considering raising interest rates at all?
The quick answer is unemployment. At 5.1 per cent, a rate equivalent to full employment in the US, the labour market there is back to where it was in 2008. For the Fed this level of unemployment equates to wage-price pressures.
Like the European Central Bank in Frankfurt, it is mandated to keep inflation close to 2 per cent. While the current rate is an anaemic 0.2 per cent, largely because of plummeting oil prices, the Fed is thinking two years down the line.
One way to control inflation is through the manipulation of interest rates. It’s a tricky business because there’s a lag between actions and results, and a myriad of variables in between, making the timing of policy decisions crucial.
For months the Fed has been telegraphing its intention to begin a modest cycle of rate hikes. However, China’s ailing economy has presented a cloud of uncertainty.
“If China turns over, they will export deflation globally,” says Gareth Grogan from Bank of Ireland Global Markets.
What he means is that China will rein in buying and depreciate its currency in the event of a large domestic downturn, making their goods cheaper abroad. That will push down prices globally. Such a scenario has the potential to wrong-foot the US, hence the Fed’s decision to hold fire. That said, a cycle of rate hikes is coming, if not now then later in the year.
So what does all this mean for Ireland?
The first phase of Ireland's recovery was driven almost entirely by a pick-up in our two biggest export countries, the US and Britain. Signals by the Fed and the Bank of England that they intend to raise rates in the short term reflects a confidence in the relative health of their economies – a good thing for Ireland.
Interest rate hikes typically prompt an appreciation in the host currency as capital flows in to avail of better returns. This means the dollar would gain against the euro, making our exports relatively more competitive, further shoring up our bumper US trade.
Equally, the buying power of US foreign direct investment, upon which the Irish economy relies, would be further enhanced by a stronger dollar, making Ireland a more attractive investment proposition.
A potential spanner in the works
However, there's a splinter in this paradigm. Not everybody believes the dollar is going to appreciate against the euro.
Alan McQuaid of Merrion Stockbrokers points to a recent Reuters poll of currency analysts, in which most believed the euro would strengthen against the US currency rather than fall to parity as many had been predicting earlier this year. “There’s a perception that Europe is lagging somewhat and has more scope to improve,” McQuaid says.
If this comes to pass our exports would become relatively more expensive and Ireland would become a costlier destination in FDI terms.
What is the ECB's role in this?
Working against this scenario is the ECB and its unprecedented €1.1 trillion quantitative easing programme which is keeping the euro pegged back against the dollar. Having the two central banks – the ECB and the Fed – pointed in different directions is a unpredictable dynamic.
Nonetheless, the start of a rate hike cycle in the US should lift interest rates globally. “The global driver of interest rates are the US treasury bonds,” says Grogan.
Rising US bond yields will drive up European yields, including Ireland’s, raising the cost of government borrowing here. However, small, incremental hikes of 0.25 per cent will hardly spook the NTMA, especially with the State’s coffers so well funded.
Where will it all end?
The US rate move, when it finally arrives, will mark the first step on a path to higher rates in Europe. This will filter down to consumers in the form of higher rates charged on loans. For variable rate mortgage holders especially, this is not something to look forward to. However, with the ECB reiterating its commitment to QE until September 2016, European rate hikes are not expected any time soon.
