Federal Reserve likely to keep interest rates steady amid economic growth

Federal Reserve chairman Jerome Powell. With our OCR at 4.25%, the unusual situation of us having a lower policy rate than the US is likely to persist a bit longer, writes Mark Lister.

KEY FACTS

• The Federal Reserve is likely to keep the Fed Funds Rate unchanged at 4.50%.
• The Reserve Bank is expected to cut the Official Cash Rate by more than 1% this year.
• The NZ dollar is weak, sitting at US$0.56, 15% below the long-term average.

The Federal Reserve in the US meets in the coming week, and there’s a good chance it leaves policy settings unchanged.

That would see the upper bound of the Fed Funds Rate, the US version of our Official Cash Rate (OCR), remain at 4.50%.

With our OCR at 4.25%, the unusual situation of us having a lower policy rate than the US is likely to persist a bit longer.

In fact, if financial markets are correct this gap is likely to widen significantly.

The Reserve Bank is expected to cut the OCR by more than 1% this year, starting with another 50 basis point reduction next month.

In contrast, markets only see one or two 0.25% rate cuts from the Fed in 2025.

There’s a lot of water to go under the bridge, but that would mean an OCR of 3.25% and a Fed Funds Rate of at least 4%.

It’s rare for us to be to below the US full stop, let alone that much lower.

Since the OCR came into being in 1999, it’s been equal to or higher than the corresponding Fed Funds Rate 86% of the time.

On average, the OCR has been 1.8% above its US counterpart.

There are a few reasons for this, including our inflation targeting framework, the higher risk profile of our small, agriculture-reliant economy, as well as a persistent current account deficit.

We’ve also had high external debt levels for some time, which means we need higher interest rates to attract capital from offshore.

Aside from the past few months, the only times we’ve had a lower policy rate were in late 1999 and early 2000, then again from mid-2018 until the start of the Covid-19 pandemic in 2020.

One outcome of this recent uniqueness is a much weaker currency.

We’ve been sitting at US$0.56 against the greenback in recent weeks, some 15% below the long-term average of US$0.66.

It’s also the lowest since 2009, when we were in the depths of the GFC and prices of our largest commodity export (dairy) were in the midst of a 65% crash.

Things aren’t quite that dire today, although our economic situation does pale in comparison to that of the US.

The US recession many have been expecting hasn’t eventuated, and the economy is looking very solid.

Job creation has hit a nine-month high, while the unemployment rate unexpectedly declined last month.

There’s also the threat of another inflationary wave as we sit waiting for detail on President Trump’s tariff plans.

That’s seen hopes for extensive Fed rate cuts dry up, pushing the greenback and longer-term interest rates higher.

The US 10-year bond yield (which drives the price of fixed-rate mortgages) has increased by close to 100 basis points since the Federal Reserve first cut rates back in September.

Job creation has hit a nine-month high, while the unemployment rate unexpectedly declined last month. Photo / 123rf

While central banks are in control of short-term interest rates, longer-term rates march to the beat of their own drum, reflecting market expectations for growth and inflation.

In recent weeks the US 10-year yield has come close to the 16-year high of 5% it briefly touched in 2023.

It’s hard to say how long this dynamic will persist across currency and interest rates markets.

In theory, it should be somewhat self-regulating.

The weak NZ dollar should give our export sector a big shot in the arm, improving its competitiveness and boosting economic activity.

It should also put upward pressure on inflation, because of higher costs for imported goods.

Those two things should make the Reserve Bank less inclined to slash the OCR too much further, and those higher interest rates should in turn support the currency.

The strong US dollar should have the opposite impact, negatively impacting multinationals and curbing growth slightly.

More than 40% the revenue from S&P 500 companies comes from outside the US, and for the high-flying technology sector it’s even higher at 56%.

Policy changes are still a wildcard, but softer earnings growth and lower import costs might give the Fed a little more breathing space.

The NZ dollar might find itself under increasing pressure over the short term, but looking out a little further we should start to see some of these stabilising factors have an impact.

Mark Lister is investment director at Craigs Investment Partners. The information in this article is provided for information only, is intended to be general in nature, and does not take into account your financial situation, objectives, goals, or risk tolerance. Before making any investment decision Craigs Investment Partners recommends you contact an investment adviser.