Fed interest rate increases: what comes next and how will it affect the UAE?

Borrowing costs in the UAE are expected to rise in line with US rates over the coming months

The Federal Reserve building in Washington. The Fed's rate increases affect the UAE as the dirham is pegged to the dollar. Reuters

The US Federal Reserve raised interest rates by 75 basis points at its meeting last week, bringing the Fed Funds rate to 1.75 per cent on the top end.

This was more than the 50bps that had been telegraphed after the May meeting, although in the days before the June meeting the market had priced in a 75bps move.

There were two data points that probably caused the Fed to accelerate the pace of rate increases: May inflation data and the preliminary University of Michigan consumer sentiment survey for June, which had been released only a few days before the Federal Open Market Committee (FOMC) met last week.

US inflation had risen by much more than expected in May and — of particular concern to the Fed — the price pressures were broad-based, going beyond food and energy.

While the consumer sentiment index fell to a record low in June, the most worrying aspect for the US central bank would have been the increase in long-term inflation expectations from 3 per cent to 3.3 per cent — well above their 2 per cent target.

The statement from the meeting showed that the FOMC is “strongly committed to returning inflation” to the Fed’s target level of 2 per cent and will be prepared to “adjust the stance of monetary policy as appropriate”.

With inflationary pressures expected to remain high in June, it seems probable that the Fed will again increase the benchmark rate by 75bps at the July meeting, before returning to 50bps increments over the remaining meetings this year. This would take the upper bound of the Fed Funds rate to 4 per cent by December, an astonishing 375bps increase from the start of the year.

The path ahead for interest rates has raised concerns about US recession risks over the next 12 months in some quarters, but the Fed still seems to think that a “soft landing” can be achieved.

The US central bank now expects real gross domestic product growth to slow to 1.7 per cent this year, down from its earlier forecast of 2.8 per cent in March, while the unemployment forecast for 2022 was revised up only slightly to 3.7 per cent, from 3.5 per cent previously.

There was a larger revision to the 2023 unemployment forecast with the Fed now expecting 3.9 per cent next year compared with 3.5 per cent previously. However, this is still a very low level of unemployment by historical standards.

As expected, the Fed also revised its inflation projections higher. But in order to achieve its new forecast of 5.2 per cent on its preferred inflation measure in 2022, inflation will need to decline every month from June until the end of the year, which looks optimistic.

Historically, the Central Bank of the UAE has moved in line with the Fed on interest rates, and it did so again last week, with the UAE base rate rising 75bps to 1.65 per cent.

We expect borrowing costs in the UAE to rise in line with US rates over the coming months, which could prove a headwind to non-oil sector growth this year as households and businesses slow borrowing to spend and invest.

This may be a welcome development in some areas of the economy, such as property, where higher rates may help to cool the rapid price growth seen over the last couple of years.

Furthermore, the UAE and other GCC governments have the option of using fiscal policy as a lever to support non-oil growth, if they choose to do so, by channeling some of their expected budget surpluses into domestic investment.

Khatija Haque is chief economist and head of research at Emirates NBD