The Fed may lift rates sooner than you think

A recovering labour market should see the US economy finish the year on a stronger note. And with inflation also tracking higher, the Fed may have reason to lift rates earlier than expected.

The Federal Reserve continues to wind down its asset purchases amid continued signs of recovery, and a move on rates could occur by early next year. The US economy rebounded somewhat during the June quarter, more than offsetting a poor first-quarter result, and with the labour market continuing to improve the outlook is bright for the second half of the year.

At its July meeting, the Federal Reserve decided to cut its asset purchasing program by a further $US10 billion. The Fed will now add to its holdings of mortgage-backed securities by $US10bn per month (from $US15bn) and also purchase $US15bn of longer-term Treasury securities (from $US20bn).

The Fed has once again reiterated that “asset purchases are not on a preset course” but it appears all but certain it will wind up purchases at its meeting in late October.

Although the labour market continues to improve -- non-farm payrolls rose at their fastest annual pace in over eight years -- the Fed notes that “there remains significant underutilisation of labour resources”. The unemployment rate fell to 6.1 per cent in June but the participation rate accounts for around half of the decline over the past year.

Graph for The Fed may lift rates sooner than you think

The Fed has signalled that rates will remain at their current level for “a considerable time after the asset purchase program ends”, which in the past has been assumed to mean around six months. On this basis, the first rate rise should be at the April board meeting next year. But with the labour market improving and with inflation pushing towards the Fed’s 2 per cent upper target for inflation, I wouldn’t be surprised if it make its first move earlier in 2015.

Activity in the US bounced back in the June quarter. Real GDP rose by 1 per cent, exceeding market expectations, to be 2.4 per cent higher over the year. This more than offset the 0.5 per cent decline in the March quarter, which was attributed at the time to unusually poor weather.

The household sector led the way, supported by rising employment, to be up by 0.6 per cent in the quarter. Particularly strong was spending on durable goods -- usually a good sign of a cyclical upturn -- which climbed 3.3 per cent.

Investment also shook off a weak first quarter to post solid gains. Growth was broad-based across categories, with non-residential investment rising 1.3 per cent and residential investment climbing 1.8 per cent.

The housing sector showed modest signs of improvement during the June quarter -- admittedly on the back of a number of mixed indicators -- but continues to be a source of risk for the US economy.

Graph for The Fed may lift rates sooner than you think

Inventory accumulation was also part of the story and contributed around 0.4 percentage points to June-quarter growth. This more than offset its subtraction from the March quarter.

Net exports continue to be a concern for the US economy and with the US dollar set to appreciate as the Fed winds down its asset purchases, it appears as though the trade balance will deteriorate further over the next couple of years.

US government spending continues to weigh on broader economic activity, falling by 0.2 per cent in the June quarter. This was the seventh consecutive decline in federal government spending. Growth in state and local government spending rebounded after a fairly weak start to the year.

Graph for The Fed may lift rates sooner than you think

But we shouldn’t get too excited about a strong June quarter result. This largely reflected an artificially weak first quarter rather than strong spending in the June quarter. On a whole, the first half of the year was pretty weak.

However, the US economy has set itself up nicely for the second half of the year. The labour market continues to improve, which should support the household sector and business investment, and suggests that the difficulties from earlier this year were only a temporary roadblock.