Dubai: GCC countries with dollar pegged currencies were quick to follow the US Federal Reserve lead in raising the interest rates.

The UAE was first in announcing the change in policy rates. The central bank of the UAE said in an emailed statement late on Wednesday that will raise interest rates applied to certificate of deposits (COD) by 25 basis points effective from Thursday. The current rate of CODs is at 1.25 per cent.

With all GCC currencies pegged to the US dollar with the exception of Kuwaiti dinar, which is pegged to a dollar heavy basket of currencies, the GCC countries follow the Fed policy rates. By raising key interest rates GCC central banks have reaffirmed their commitment to the dollar peg.

While the central banks in Saudi Arabia the UAE, Kuwait and Bahrain raised their key policy rates by 25 basis points, Saudi kept its repo rates, the rate at which Saudi Arabian Monetary Agency (SAMA) lends to the banks, unchanged at 2 per cent. A SAMA statement said the decisions were in response to developments in domestic and international financial markets.

In December 2016, when the Fed hiked the rates by 25 basis points, SAMA kept the repo rates unchanged with an eye on keeping the banking sector liquid while keeping a lid on cost of funds in the domestic market.

Analysts say the future trajectory of lending rates in the UAE and the rest of GCC will largely depend on the Fed rates outlook. From February there has already been a moderate increase in Emirates interbank offered rates (Eibor) on the rising expectation of a US rate hike. In addition to Fed rates outlook, oil prices and overall liquidity conditions will determine local lending rates.

“Markets will particularly focus on future projections and the tone of the guidance from the FOMC meeting, particularly if there are any indications of a June rate hike,” said Monica Malik, chief economist of Abu Dhabi Commercial Bank.

The currency peg of the dirham and other GCC currencies to the dollar means that local interest rates have to be aligned to those of the dollar. The key question is how many further increases in the interest rates will there be this year?

“There are several factors that drive this decision, including, targeting inflation at 2 per cent; getting the unemployment rate under control and attaining a ‘normalised’ interest rate. In our view, a return to normal interest rates justifies more increases in the US Fed’s interest rates and consequently in the GCC,” said Abbas Basrai, Partner — Financial Services, KPMG Lower Gulf.

Economists say the Fed’s tone on Wednesday was milder than the market expectations of a more hawkish language and an upgrade in economic projections which didn’t happen. Analysts describe yesterday’s hike as a ‘dovish hike’ or ‘neutral’ at best. The little tweaks in the statement and economic projections suggest that the economy is still moving on the right path, but there’s no evidence of overheating.

“Inflation forecasts remained unchanged at 1.9 per cent for 2017, the GDP forecast for 2018 was revised slightly higher by 0.1 per cent, and most importantly the dots didn’t move much, indicating that only two rate hikes remain for the rest of the year,” said Hussein Sayed, FXTM Chief Market Strategist.

Despite the reduced probability of a June hike, analyst say monetary tightening in 2017 will continue to act as a headwind to any pickup in economic activity in the GCC this year. The US rate hiking cycle will also underpin dollar strength, which will continue to erode the export competitiveness of the GCC’s non-oil sector. This will particularly impact the UAE, with its more diversified economy and likely result in more price discounting to support competitiveness.