Australian dollar slumps as Fed hints at earlier rate rises

The battle on the Federal Reserve between the 'hawks' who want to raise rates and 'doves' who want to keep them lower for longer is finely balanced, and has a direct effect on the Australian dollar and local interest rates.

In its meeting overnight, the US Federal Reserve hinted at earlier and steeper interest rate rises, even as it pledged to keep rates near zero for a "considerable time."

In the battle between 'doves' and 'hawks' on the Fed's key Open Market Committee, it appears the latter are slowly gaining the ascendancy, pointing to the increasing likelihood of a rate rise in the first half of next year.

Even the Fed's chair Janet Yellen, widely perceived as a dove, was keen to emphasise qualifications to the central bank's commitment to low rates.

"It is highly conditional, and it is linked to the committee's assessment of the economy," she said at the quarterly press conference after the meeting.

"There is no fixed mechanical interpretation of a time period."

An increasing number of analysts are interpreting this as Yellen giving herself the wriggle room to crawl out of earlier commitments to keep rates lower for longer.

"Yellen may be a hawk in dove's clothing because she keeps reiterating that economic data can change the pace of rate hikes and the path to normalisation," New York-based senior market strategist at Voya Investment Karyn Cavanaugh told Bloomberg.

"The economy is gaining steam, I think we could see some increase in rates by March or sooner."

Joining the dots: rate hike likely by June

The Fed publishes a useful box on its member's judgements about what appropriate interest rates are likely to be in the future.

Only one Fed member is pushing for a rate rise this year, but just two do not see one happening before 2016 - so the clear majority view (14 of 17) is for rates to rise next year - this much we already knew before the latest meeting.

Of the majority who see rates rising next year, most see them ending 2015 between 1-2 per cent, with only six seeing them staying below 1 per cent.

The typical estimate is for the benchmark funds rate to finish next year at 1.375 per cent, which is 25 basis points higher than the June forecasts.

To get interest rates to that level, the Fed will need to start sooner rather than later, blowing forecasts of a first hike in late 2015 out of the water.

However, Societe Generale's US-based economist Aneta Markowska says there are signs that Janet Yellen's forecast for rates is at the lower end of the committee's range, and that makes a rate rise early in the new year very unlikely.

"The outcome of today's meeting greatly reduces the risk of a March rate hike, and is fully consistent with a June liftoff in rates," she wrote in a note on the meeting.

"While the Fed continues to guide towards a steeper tightening cycle than currently implied by the market, we do not see any immediate catalysts for a re-rating of market expectations."

Employment, wages and inflation the key

There are three possible, and related, catalysts for such a forward and upward shift in US rate forecasts: employment, wages and inflation.

If any of those start taking off, especially if all of them do, then it could force the Fed into earlier and more aggressive rate rises.

Arguably employment has already taken off, with the US jobless rate back to just above 6 per cent, down from a peak around 10 per cent during the Great Recession.

US unemployment is around the same as Australia's, and trending down rather than up, yet its interest rates remain 2.5 percentage points lower.

In her press conference, Janet Yellen explained why she does not think the US labour market is as healthy as the jobless figure implies.

"There is still too many people who want jobs but cannot find them; too many who are working part time but would prefer full-time work; and too many who are not searching for a job, but would be if the labor market was stronger," she said.

However, if that unemployment rate continues to shrink below 6 per cent, and particularly if wages start growing more strongly, that will be a sign that the US economy is returning to full health - and a warning that rising inflation may soon follow.

US rate rises may trigger Australian moves

As the muted market reaction to last week's stellar - though widely doubted - Australian jobs data versus the overnight reaction to the Fed's comments showed, US employment data is likely to be just as, if not more, relevant to the Aussie dollar as the local situation.

The growing shift of Fed committee members towards higher interest rate expectations sent the Aussie dollar tumbling almost one-and-a-half cents overnight, firmly breaking below the 90 US cent mark to 89.5.

If the US data continues to strengthen, that will do more to pull the Australian dollar down to more comfortable levels than any actions the Reserve Bank of Australia could reasonably take.

That weaker dollar, in turn, may be the factor that stops Australia's upward trend in unemployment, perhaps giving the Reserve the freedom to start thinking about raising local rates to head off a housing investment boom that is making it increasingly uncomfortable.