Fed rate hike may come sooner than expected, says Swiss Re Chief Economist, Kurt Karl

After today’s decision by the Federal Reserve to maintain the target Fed funds rate at zero to 25 basis points, Swiss Re’s Chief Economist, Kurt Karl believes that with strong growth in the US economy virtually assured for the rest of the year, the Fed's forward guidance will at first become neutral and then begin hinting about a future tightening.

Karl says: "Now that the inventory buildup in the first quarter – affected by the severe winter weather – has been estimated to be much smaller, the US is poised for a strong Q2 rebound. The second half of the year should also have robust growth, which will set the stage for modest interest rate hikes in early 2015. Currently, the Fed funds rate is forecast to reach 1.75% by end-2015, which is still a very low level. The yield on the 10-year Treasury yield will rise to 3.25% by end-2014 on strong growth and the anticipation of a rate hike and to 4.0% by end-2015 because of the rising fed funds rate."

Aside from the rapidly declining unemployment rate, the Fed will be closely watching wage gains. The latest employment report had total private hourly earnings up 2.1% year-on-year in May, compared to 1.8% for core inflation. Wage increases have been slowly accelerating as employment conditions improve. Thus, the Fed, faced with very low interest rates, will need to begin tightening earlier than in prior cycles.  

Karl adds: "Of course, if growth and inflation begin to turn upward rapidly, the Fed could move even earlier, but this scenario has a low probability. On the other hand, benign wage gains and modest growth would delay an initial Fed rate hike well into 2015."

The ECB cut the deposit rate into negative territory last week and announced a targeted Long-Term Refinancing Operation to spur lending to SMEs, particularly in peripheral countries. However, we expect these measures to be of limited effectiveness. The moves are likely to prove more effective at boosting confidence than at accomplishing their stated goals.

"The Euro area is likely to grow by about 1.0% this year and nearly 1.5% next year," says Karl. "Though there were some initial expectations that growth could be revised up this year, first quarter growth was very consistent with 1% growth for the year. Yields on the 10-year German bunds will rise to 1.9% by end-2014 and to 2.5% by end-2015. Meanwhile, the UK economy continues to strengthen and growth is projected to be 3.0% this year and 2.5% next year. Inflation will be slightly below 2% and yields on UK 10-year government bonds will rise along with US interest rates to 4% by end-2015."

Prospects in China remain unchanged – real GDP growth will likely be between 7% and 7.5% this year and next. Inflation is reasonably benign – about 2.5% currently – and central government debt is not high, so the Chinese authorities still have plenty of leeway to ensure growth is above 7%. The economy has a high level of debt to GDP, however, so the government has a delicate balancing act between moderating credit expansion and stimulating economic activity.  

Karl concludes: "In Japan, as expected, the current quarter real GDP growth is shaping up to be negative due to the spending in Q1 before the onset of the April 1st sales tax increase. Growth will resume in Q3 and average close to 1.5%, before slowing to 1.2% next year. The tax increase will push inflation above 2%, but only for this year. Next year, inflation will be closer to 1.5%."

Swiss Re

The Swiss Re Group is a leading wholesale provider of reinsurance, insurance and other insurance-based forms of risk transfer. Dealing direct and working through brokers, its global client base consists of insurance companies, mid-to-large-sized corporations and public sector clients. From standard products to tailor-made coverage across all lines of business, Swiss Re deploys its capital strength, expertise and innovation power to enable the risk-taking upon which enterprise and progress in society depend. Founded in Zurich, Switzerland, in 1863, Swiss Re serves clients through a network of over 60 offices globally and is rated "AA-" by Standard & Poor's, "Aa3" by Moody's and "A+" by A.M. Best. Registered shares in the Swiss Re Group holding company, Swiss Re Ltd, are listed in accordance with the Main Standard on the SIX Swiss Exchange and trade under the symbol SREN. For more information about Swiss Re Group, please visit: www.swissre.com or follow us on Twitter @SwissRe.