What would a US interest rate hike mean for British business?

The Federal Reserve has dropped another hint at a rate rise, but it may not be as big as we thought.

by Adam Gale
Last Updated: 17 Jul 2015

In the depths of the financial crisis in late 2008, the US Federal Reserve brought its interest rate target* down to 0-0.25%, flooring the gas in an effort to drive the world’s largest economy from the edge of recession. It didn’t work, and interest rates have remained at historic lows ever since. But there are signs that the era of cheap money is coming to an end.

The Fed has removed the word ‘patient’ from its latest monetary policy statement, indicating that its long wait to raise rates may be nearly over. ‘Patient’ seems to be code for ‘don’t expect a change any time soon’ – indeed, the last time the Fed took the word out in 2004, a raise followed the very next month.

Markets normally tumble at rate rises (or even hints of them), because equities become less appealing investments relative to bonds. Why, then, did the Dow Jones Industrial Average rise 1.3% on the news yesterday? Why has the FTSE 100 reached a new record intraday high today, at 6,982?

The reason is that the Fed also revised its interest rate projections down, to 0.625% by the end of 2015. In December it projected 1.125%. The hike that everyone expected now looks likely to be fairly small. ‘Just because we removed the word patient from the statement does not mean we are going to be impatient,’ said Fed chair Janet Yellen. But of course.

How will it affect the UK?

In the US, the main impact of the rate rise when it eventually comes will be to put a brake on economic activity and to slow any rise in inflation. From a British perspective, it’s mostly about currencies. Get ready for some FX tailwinds...

Higher interest rates in the States will make holding dollars more appealing, so tending to increase the value of the greenback relative to other currencies. This will help British exporters, by making their goods and services cheaper in the US.

Compared to sterling, the US dollar already resembles an Icelandic strongman pulling an aeroplane by its teeth. In July, a pound would buy $1.72; now it’ll get you $1.49 – a 13.4% fall. Businesses that export to the US – from Scotch distilleries to luxury car companies and pharmaceutical firms – can expect a bumper year as the buck gets even beefier.

Conversely, imports from the US will become dearer. This could hit businesses from cinemas showing the latest Hollywood blockbusters to your local Apple store. As the UK is already a net exporter to the US, however, the overall impact should be positive to UK plc in terms of purely American trade.

On the other hand, British firms depend on many markets and a surging dollar would have a global impact. Oil and mining firms won’t be helped by a stronger greenback, which effectively reduces the prices of those commodities denominated in dollars (all of them).

At the same time, businesses like Prudential and Standard Chartered probably won’t welcome the impact a strengthening dollar could have on emerging markets, on which they depend. It effectively increases the cost of dollar-denominated debt in those countries, and creates the risk of capital flight to the US.

IMF chief Christine Lagarde warned this week that emerging markets could suffer from a repeat of 2013’s ‘taper tantrum’, when hints of a slowing of America’s QE programme had exactly this effect. ‘Even if [the rate rise] is well managed, the likely volatility in financial markets could give rise to potential stability risks,’ she said.

The Bank of England

When it comes to monetary policy, the US and UK have been in close harmony over the last few years. The US rate rise may bring that to an end, as Bank of England boss Mark Carney has given no signs of a hike here any time soon.

With inflation at historically low levels, thanks in part to the oil price collapse, Carney’s concern seems to be more about growth and the strength of sterling. While the pound has withered in the face of the mighty dollar, it is treading all over the QE-addled Euro, currently trading at €1.39, up 8.8% since the beginning of the year.

As Britain trades far more with the EU than the US (roughly three times, in fact), this has a far bigger impact on our economy, and a rate rise here would only make the matter worse.

Both the Bank of England and the Fed expect inflation to rise over the next few years, and interest rates will surely do the same in both countries, even if we don’t know when. Better get ready for the era of cheap money to come to an end then, unless you happen to live in the Eurozone. No chance of any rate rises there.

*Central banks aren't able to impose interest rates by fiat. Instead, they set targets and influence the rates commerical banks offer, primarily by setting the rate at which they lend to banks (the deposit rate) and by buying and selling securities.

To raise the rate, central banks buys bonds, reducing the supply of cash in the economy. This means commerical banks have to offer greater incentives for people and businesses to deposit that cash, while scarcer money effectively increases the market price of a loan. If the Fed or Bank of England wants to lower the rate, it does the opposite and sells securities.

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