Fed sees slower interest rate rise path

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The Federal Reserve has maintained the Federal funds rate steady at 0.25%-0.5%. In December 2015, the Federal Reserve offered guidance in its plan to raise the Federal funds rate by 1% in 2016, most likely in 0.25% increments. The Federal Reserve’s updated quarterly projections saw the rate increase by two 0.25% movements rather than the four forecasted in December. The scaling back on the rate hikes in the US has been attributed to weakness in the global economy and volatility in the US financial market. The ‘accommodative’ stance of the Federal Reserve is intended to support improvements in labour market conditions and enable inflation to return to its 2% target.

How does this relate to the HSC syllabus?

  • The decision to maintain the Fed funds rate and to reduce the forecasted rate increases throughout the year is largely attributed to weak global economic growth and turmoil in the US financial market. Weak US net export data can be attributed to weak global economic growth. Weakness in global economic growth can negatively impact US economic growth given that the US relies on the global economy to purchase its exports (HSC Topic 1 – The Global Economy). In particular, the Federal Reserve has indicated that uncertainty as to China’s future growth poses as a risk to US growth. As such, uncertainty surrounds the US’s future economic growth justifying keeping the rate ‘accommodative’.
  • Domestic US economic growth has been solid. Although investment by businesses and net exports have been flat, consumption has seen an improvement. Given that consumption typically contributes to around 50% of economic growth, the US economy has experienced stable growth (recall that AD = C + I + G +(X – M)) (HSC Topic 3 – Economic Issues). Keeping the Fed fund rate steady means that borrowing rates mean that businesses and individuals can borrow money more easily to invest and consume which will increase aggregate demand an in turn continue to increase economic growth.
  • Inflation, at 1% in February, remains under the Federal Reserve’s target inflation objective of 2%. Given that an objective of macroeconomic policy such as monetary policy is to control and maintain inflation at a manageable rate, the Fed funds rate was kept stable to help inflation increase to the 2% target. Low inflation figures were attributed to the falling price of commodities, in particular, oil, which have seen energy prices fall. As such, price levels in the economy has fallen leading to lower inflation (HSC Topic 3 – Economic Issues).
  • Another objective of macroeconomic policy is to promote full employment. Employment figures in the US have been strong as the projection for unemployment in 2017 fell from 4.7% to 4.6%. In the short term, the unemployment rate matches the Federal Reserve’s target for full employment. However, the low wage growth currently being experienced in the US suggests that the labour market has potential to grow, supported by lower borrowing rates.
  • Although the US was seen to maintain the Fed rate steady this month, it continues to maintain a tightening stance overall (Preliminary Topic 5 – Financial Markets; HSC Topic 4 – Economic Policies and Management). This is in direct contrast to the loosening stance taken around the world with Japan and Europe recently implementing rate cuts that see their cash rates fall below zero.
  • The fact that the Federal Reserve did not raise the Fed funds rate and reduced the forecast number of rate hike from four to two has caused the Australian dollar to appreciate. Given that the Australian cash rate is one of the highest in the world since Japan and Europe have implemented negative cash rates, foreign investors have been investing in Australian bonds to benefit from their higher yields. Since investment into Australian bonds requires Australian dollars, demand for Australian dollars increased causing an appreciation to around US$0.75 (HSC Topic 2 – Australia in the Global Economy). Had the Federal Reserve increased rates, the Australian dollar most likely would have depreciated given that investors would increase their investment into US bonds to earn their higher expected yields.

APRA talks about how it stopped ‘loose banking’ practices

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Prior to the housing boom, there was evidence to suggest that banks were engaging in risky lending practices. APRA intervened as the ‘culture of not being able to assess good borrowers from bad ones’ become apparent and less creditworthy individuals were receiving loans. Focus was placed on short term profit in the face of increasing competition between the banks. Measures taken by APRA in order to minimise the risk of lending to less creditworthy customers includes the increase in capital adequacy requirements for residential property in 2015 and higher interest rate buffers of up to 2% on the home loan rate. These measures have resulted in a strong financial system which is less affected by housing shocks.

How does this relate to the HSC syllabus?

  • The Australian Prudential Regulation Authority’s role is to supervise and enforce a regulatory framework on Australia’s financial system (Preliminary Topic 5 – Financial Markets). As the banking system began to make risky lending decisions in the interest of making short term profit, APRA exercised its supervisory role by imposing stricter lending laws onto banks such as higher capital requirements and interest rate buffers.
  • Banks were increasing their target market for housing loans by taking into account factors that would make customers seem more creditworthy. For example, some banks were taking into account non-wage and salary income sources such as bonuses, rents on existing investment properties and negative gearing benefits.
  • Lending to less creditworthy customers could be damaging to the economy. Less creditworthy customers are less likely to repay their loans and face higher interest rates which can lead to bank losses when such customers default. Approving housing loans to a large group of such customers has the potential to cause large losses in the banking system. The global financial crisis was partially caused by looser lending standards which saw uncreditworthy individuals who managed to get loans default on these loans, causing a significant decrease in bank liquidity.
  • APRA’s imposition of higher capital requirements decreases the banks’ lending abilities since more cash must be kept in the bank’s reserves. This restricts lending to all customers but to uncreditworthy customers in particular since banks would rather lend their limited funds to safe, creditworthy customers. In doing so, APRA ensures the stability of the financial system by reducing the probability that banks would lend to customers who would likely default on their loans (Preliminary Topic 5 – Financial Markets).

A quarter of bank revenue may be lost to disrupters: PwC

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Incumbent banks such as Commonwealth Bank and ANZ are expected to experience a loss of up to a quarter of their revenue within the next 5 years to financial technology (FinTech) companies. PwC surveyed more than 500 people working in banks from 46 countries worldwide. Over 50% of respondents expected FinTech companies to put downward pressure on their margins and take from some of incumbent bank market share. Respondents were also optimistic that FinTech could reduce costs in their businesses and increase focus on their customers. Adoption of FinTech, however, could take at least 12 months to adopt for large companies.

How does this relate to the HSC syllabus?

  • FinTech companies are those which use technology to make financial services more efficient. Given that FinTech companies also supply financial services to the market, they can be viewed as a substitute (Preliminary Topic 2 – Consumers and Business). Furthermore, given that these companies leverage technology to automate their functions and make their processes more efficient than incumbent bank at the similar or lower prices, consumers would likely drift to FinTech companies in the medium to long term.
  • The entrance of financial technology and its disruption to incumbents in the financial sector represents a technological change that is threatening the profits as consumers move towards FinTech companies (Preliminary Topic 2 – Consumers and Business). The drift towards FinTech is making it more difficult for incumbents in the financial sector to meet its goals to maximise profit.
  • As FinTech companies become more prominent, they will increase their market share which will detract market share from existing players. As such, incumbent companies will also find it more challenging to meet its goal to maximise market share (Preliminary Topic 2 – Consumers and Business).
  • Examples of FinTech include: transferring funds through mobile, new ways for small businesses to raise capital, alternative payment methods and peer-to-peer lending.


Theresa DangTHERESA DANG

Theresa Dang is an economics mentor at Keystone Education. She attended Sydney Girls High and achieved an ATAR of 99.70 in 2012. She is now studying Commerce and Law at the University of Sydney. She has experience in a global technology firm and a mutual fund.


Gary LiangGARY LIANG

Gary Liang is the founder and director of Keystone Education. He attended Sydney Boys High and achieved an ATAR of 99.95 in 2012. He achieved 5 state ranks in Mathematics, Mathematics Ext 1, Mathematics Ext 2, Chemistry and Economics. He is now studying Economics and Science (Advanced Mathematics) at the UNSW Australia, where he is the recipient of four scholarships.

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