On Wednesday the U.S. Federal Reserve Chair Janet Yellen put an end to months of speculation when she announced the tightening of US monetary policy with a much-anticipated rise in interest rates by a quarter-percentage point.
Bolstered by positive gains in the job market (unemployment in the US is now down to 5%), Yellen’s decision marks the end of an historic era of near-zero interest rates in the US dating back to the global financial crisis in December 2008.
[For more read: What a Fed rate hike will mean for Africa]
For America, the move will signal that the Fed is now more confident that it will meet its objective of lifting inflation, which is currently at 0.1%, to around 2% over the medium term and that the US economy is strong enough to withstand the gradual normalisation of interest rates, currently effectively at 0%.
Despite Yellen indicating that the impending round of rate hikes will be slower and peak lower than previous cycles, there is still considerable risk to global financial markets and currencies from an expected lengthy period of Fed tightening. A key difference now compared with the past few cycles is that Fed tightening is highly unlikely to be followed anytime soon by the other major central banks around the world. This could mean a further firming of the US dollar and more pressure on global commodity prices.
The US economy itself will not escape unscathed as a loss of export competitiveness and lower earnings from US companies’ offshore operations will eventually have a negative impact on the US too. Add to this the sustained sluggishness of the Chinese economy and increased uncertainty and likely higher market volatility is almost a given, as has already been the case in recent weeks.
Global outcomes could be better if expansionary policy settings elsewhere around the world were to finally trigger a more robust recovery there. Firmer growth outside of the US will reduce the risk to the global economy from Fed rate normalisation and will likely also stem dollar strength.
For emerging economies, like South Africa, the anticipation of the Fed’s first rate, played out via a surging dollar, has done a lot of damage far ahead of the actual first hike. As the dollar has strengthened, commodity prices were driven lower and forced some countries, South Africa included, to raise interest rates. In short, falling commodity prices imply a transfer of wealth from commodity producing nations to consuming nations. Many developing countries, after a decade of strong commodity prices and handsome income and wealth gains, learnt this lesson painfully over the past year or so.
The problem is that these troubles may not be over and a renewed bout of dollar strength could cause yet another round of pain in emerging economies.
South Africa indeed faces a difficult 2016, not only because of weak commodity prices, tighter monetary and fiscal policy and the impact of the drought, but the sharp fall of the rand following the recent drama around the axing of previous Finance Minister Nhlanhla Nene, will likely trigger a stronger inflation rise than expected up to now and may also force the South African Reserve Bank to raise rates more and/or earlier than expected up to now.
If South Africa is to thrive economically in this more difficult world it will have to implement market-friendly economic reforms as a matter of urgency. Failing to do so will likely keep growth weak, the rand under pressure and will cause social pressures to build further. The urgency to implement reforms is rising by the day.
The US Federal Reserve has clearly communicated its intention to raise interest rates. This has given the market sufficient time to get to grips with the consequences of this lift-off. That said, the real question relates to the extent of the cycle this time around − in other words, the frequency and magnitude of these rate hikes. The US was the first to implement extreme monetary policy easing and has been the first to start recovering from the fallout of the global financial crisis. Europe and Japan are engaged in their own bout of quantitative easing in order to resurrect their economies. Meanwhile, emerging economies are trying to come to terms with a structural slowing of their growth rates.
This means that developed equity markets should continue to perform well as their growth outlook improves. Emerging equity markets could remain under pressure in the face of slower economic growth, particularly those linked to Chinese commodity demand. Although the US dollar has strengthened somewhat, a continuation of this move is possible, given that the US is the only country raising rates which, in turn, may result in additional downward pressure on commodity prices and emerging market currencies. Despite underperforming significantly in recent years, the resources sector could then see further weakness should commodity prices experience another leg down. However, we would expect South African counters with a significant non-resource global footprint, such as Steinhoff, Mondi and Bidvest, to hold up well given the better global growth outlook.