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Abu Dhabi, UAEFriday 21 September 2018

 Be prepared: higher interest rates and inflation are on the menu

In the Arabian Gulf, the various GCC central banks have the same policy targets as the US fed

Newly installed Federal Reserve Chairman Jerome Powell speaks following the Federal Open Market Committee meeting in Washington.Carolyn Kaster/AP
Newly installed Federal Reserve Chairman Jerome Powell speaks following the Federal Open Market Committee meeting in Washington.Carolyn Kaster/AP

As anticipated, the US Federal Reserve chairman Jerome Powell turned in a very clear first press conference as Fed chief to cap off what seemed a straight down the line Federal Open Market Committee (FOMC) meeting statement.

This supported a consensus for more American interest rate rises shortly after the widely anticipated Fed decision to lift the federal funds rate target range of 1.5 per cent to 1.75 per cent in an 8-0 vote. Fed officials, meeting for the first time under Mr Powell, raised the benchmark lending rate a quarter-point and forecast a steeper path of hikes in 2019 and 2020, citing an improving economic outlook. Policymakers continued to project a total of three increases this year. This also points to another rate hike in June and further room on the upside in something of a staggered reaction to fiscal stimulus. Once again curtailing inflation seemed paramount, as this was the Fed’s anchor target for more rates rises. Also in the Fed chairman’s statement, the US central bank said inflation on an annual basis was “expected to move up in coming months”, after saying “move up this year” in the January statement. Price gains are still expected to stabilise around the Fed’s 2 per cent target over the medium term, the FOMC said, showing that the tone and style of the message is as important as the action itself.

The Fed's ability to continue its gradual pace of rates normalisation may depend on inflation dynamics over the coming months. Markets started to forecast such increases and the median fed funds range for the end of 2020 rates was projected at 3.25 per cent to 3.5 per cent.

It did not take long for Arabian Gulf central banks to step in line with the Fed move and Kuwait raised its key interest rate for the first time in a year, tracking the quarter-point increase in the US benchmark rate. Kuwait’s central bank raised the discount rate to 3 per cent to keep the dinar competitive, and avoid a capital outflow of the dollar. The UAE, Qatar and Bahrain, also raised their benchmark rates shortly after the Fed decision. Gulf Arab central banks that peg their currency to the dollar typically follow Fed decisions in lockstep, but Kuwait pegs its dinar to a basket of currencies and chose to sit out the previous two increases in US rates in 2017 in order to preserve growth and keep down borrowing costs. Given the strength of the dollar against the Euro, it comes as no surprise that Kuwait has decided to go along with the Fed this time and the Kuwaiti central bank said it did so to maintain the competitiveness of its currency and keep local savings attractive.

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The UAE raised its repo rate by 25 basis points to 2 per cent, and increased its certificates of deposit rate by the same amount. Bahrain raised its overnight deposit rate by 25 basis points to 1.75 per cent, and its one-week deposit facility rate by a quarter point to 2 per cent. Qatar raised its deposit rate by the same amount to 1.75 per cent, while keeping it’s lending and repo rates at 5 per cent and 2.5 per cent respectively.

In a surprising development, Saudi Arabia did not announce a move, having pre-emptively increased its benchmark repo rate the previous week for the first time since 2009. Usually it had followed any US rate decision. According to the Saudi central bank, the move to raise the repo and reverse repo rates was aimed at stabilising the exchange rate. The Saudi Arabian Monetary Authority hiked its repo rate from 200 basis points (bps) to 225 bps and also raised its reverse repo rate by 25 basis points to 175 bps. This, in turn, will help stabilise inflation in the kingdom by maintaining import prices, according to Assim Al Ghursan, director of the monetary policy and financial stability department at Sama.

Are the forecast increases in US interest rates a certainty? From the voting patterns of the FOMC, the latest set of quarterly forecasts showed that policymakers were divided over the outlook for the benchmark interest rate in 2018. Seven officials projected at least four quarter-point hikes would be appropriate this year, while eight expected three or fewer increases to be warranted. The Fed’s goal is to keep supply and demand in balance in the economy amid a tight labour market, without lifting borrowing costs so quickly that the economy stalls. Officials have had to factor in the impact of fiscal stimulus signed by US President Donald Trump since their previous projections. The committee’s forecast for the long-run sustainable growth rate of the economy was unchanged at 1.8 per cent, suggesting policymakers are still sceptical of the effect of tax cuts on the economy’s capacity for growth. The 2020 GDP growth median projection was also unchanged at 2 per cent.

In the Gulf, the various GCC central banks have the same policy targets in controlling inflation and ensuring there is enough liquidity in the banking system to support economic growth without lifting borrowing costs too sharply and curtailing the “green shoots" of recovering economic activity. Such long-term forecasts of interest rates should assist the Gulf private sector to factor in the changes and adjust their asset and liability financial and cost models accordingly. They have only themselves to blame if they miss these signals and continue ostrich like in trying to second-guess where interest rates are heading.

Dr Mohamed Ramady is an energy economist and geo political expert on the GCC and former Professor at King Fahd University of Petroleum and Minerals, Dhahran, Saudi Arabia and co-author of ‘OPEC in a Post Shale World – Where To Next ?’. His latest book is on ‘Saudi Aramco 2030: Post IPO challenges'.

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