Is the Fed set to pause next week?

The Federal Reserve in the US meets next week, and there’s a good chance they do nothing.

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

With our OCR at 4.25 per cent, 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 one per cent this year, starting with another 50 basis point reduction next month.

In contrast, markets only see one or two 0.25 per cent 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 per cent and a Fed Funds Rate of at least four per cent.

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 per cent of the time.

On average, the OCR has been 1.8 per cent 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 level 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 per cent 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 per cent 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.

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 five per cent 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 including 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 per cent 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 per cent.

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.

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