Today’s Headlines: At Long Last, the Fed Raises Rates

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Today’s Headlines: At Long Last, the Fed Raises Rates
December 22, 2015

They Finally Did It

For the first time since the financial crisis, the Federal Reserve pulled the trigger on raising interest rates last Wednesday. They boosted the baseline short-term rate by 0.25% to a range of 0.25%-0.5%, thus ending seven years of near-zero interest rates.

The equity markets knew this day was coming and initially reacted with approval. The Dow Jones Industrial Average ended up 224 points Wednesday after the Fed announcement, while the S&P 500 and NASDAQ each rose around 1.5%. Global stock markets rallied as well Thursday and Friday, with Japan’s Nikkei up 1.6%, Germany’s Dax surging 3%, and the broader Euro Stoxx 50 index climbing 2.5%. While all these indices retreated somewhat by market close on Monday, they are still positive since the Fed announcement.

The volatile US equity markets had second thoughts however, with the Dow falling 620 points to finish the week down 153 points, and the S&P and NASDAQ also sustaining net losses since the

Fed announcement. What then is the consensus view of domestic equity markets on the Fed rate hike? Politely stated, it is mixed. Less politely, downright schizophrenic.

The Treasury market – which classically falls when interest rates rise — also provided some drama by rallying since the Fed announcement due to a spike in market demand for US Treasury securities. This spike notwithstanding, the longest sustained bond market rally in generations is likely over with the Fed announcement on Wednesday.

All of this begs the question: is the effect of interest rates on the economy overstated? Not really, but the effects can be misunderstood and amplified in short-term ways that can misrepresent the true long-term outlook.

Watch Your Speed

Despite the roller coaster ride in US equity markets since the Fed announcement (major indexes rose again on Monday), it’s clear Wall Street is not panicking over the prospect of an incremental, moderate rise in borrowing costs. This has more to do with what the Fed said on Wednesday than what it did.

Fed Chairwoman Janet Yellen used the term "gradual" to describe future interest rates and the return to a more normal set of conditions. Markets understand that a slow return to higher rates is not only inevitable, but also overdue, and that the economy can absorb these rate increases gracefully. The consensus projection of Fed policymakers was for multiple small rate hikes throughout the year to end 2016 at 1.25%-1.5%, but a majority of economists polled by Reuters expects fewer rate hikes and a year-end target closer to 1%. None of this spells doom to Wall Street, especially as current rates of interest and inflation are historically low.

How low? Consider that from 1971 to 2015, the average interest rate was 5.93% and the average rate of inflation was 4.1% (although the historical inflation average since 1913 is 3.18%). Currently, both inflation and the Fed rates are near zero.

Clearly, the Fed has a multiyear task ahead to get inflation to the 2% target while gradually increasing rates. Normally, Fed rates are raised to prevent or control inflation, but the Fed is taking action in spite of a lack of inflation because it feels that inflation is being dampened by temporary factors like low oil prices.

Another unspoken reason for the Fed's action may lie with correcting other side effects of low interest rates. Asset bubbles form when low interest rates increase investor appetite for risk via cheap money, and asset classes become overvalued and dangerous — such as the housing market prior to the Great Recession. Similarly, during times of low interest rates, equities are the only place to get decent returns. Thus, equities become overvalued relative to overall economic growth.

Don't Forget About the Bond Buying Program

Recall that interest rate cuts were only half of the stimulus approach; bond buying was the other. At the beginning of 2008, the Fed held just below $750 billion in US Treasuries of all maturities. After the collective rounds of bond buying, the Fed's balance now stands just above $2.46 billion — over three times its previous balance. At some point, the Fed will have to bleed some of that balance back into the bond market without causing chaos there. That task will take many years.

Meanwhile, if the economy begins to falter again, what can the Fed do? It can only add to the massive bond buying balance (as in Japan), or consider cutting again and even going negative with interest rates (as in Europe). So far, none of these stimulus efforts has produced proportionate growth anywhere in the world. Perhaps Central Banks do not have as much effect on economic growth as we like to think.

Note that all the recent stimulus packages are composed of both bond buying and interest rate cuts. Interest rate adjustments alone cannot create demand out of thin air, nor can simply pumping money into the economy through bond purchases. It depends on how that money is used — or not used.

One could argue that slow growth was the best that could be hoped for in the US given the depths of the Great Recession, but it is fair to ask if governmental policy decisions and regulatory issues are hampering Central Bank efforts.

In the case of the US recession, too much of the cash pumped into the economy was "stuck in the system" within banks and businesses just sitting on cash due to lack of demand or suitable investment options. Government spending as of late has been generally inefficient at producing lasting growth. Consumer confidence has not been strong enough to drive consumer demand and credit has been tight, and thus the money pumped into the system through bond buying had no viable outlet to reach consumers eventually through higher wages.

The real problem is efficiency of the monetary mechanisms. The economy is so intertwined that a small change in interest rates can easily be swamped by other factors, both foreign and domestic. Interest rate effects aren't as clean as market reaction would have us believe.

The Takeaway

Signs point to a balancing act by the Fed for quite some time. They will slowly raise interest rates and bleed bonds back into the market, while weighing the potential for inflation or suppressed growth along the way. Most economists believe they have started in the right direction.

Eventually, you may see a more dramatic effect in mortgage rates and savings rates. If you plan to buy a home, it is wise to do so while interest rates are low, but there is no need for panic buying yet. Accelerate your savings if possible to acquire the down payment you need, but don't overextend yourself with a home purchase. Scale back if you must.

If you’re a bond investor, you know that bond prices move in the opposite direction of yields, so the value of your fixed income portfolio will slowly erode as interest rates gradually rise. Therefore, it might be a good time to rebalance the relationship of bonds to other asset classes you hold. As for your stock portfolio, nothing has fundamentally changed. Slow growth is very likely for the foreseeable future, as the Fed will try to avoid injecting any more stimulus into the market through either reversing rate hikes or buying more bonds. With Fed intervention unlikely, there is no obvious driver of growth beyond our current slow rates (around 2.4%-2.5% annualized).

Give the Fed credit for acting even with no sign of inflation. Fiscal normalcy may be a long way off, but at least we have started the journey.


Photo ©iStock.com/pablographix

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Carla Truett | 12.22.15 @ 18:01
I dread this since we have a floating interest rate on our mortgage.
Erin | 12.22.15 @ 18:02
It's good to hear that normalcy is on the way. I don't like the increased rates, but if it leads to a healthy economy, so be it.
Irene | 12.22.15 @ 18:04
It would be nice to get more than .00009% interest on my savings
trish | 12.22.15 @ 18:05
I am obviously nervous to see how this financially affects us. But heading for normalcy sounds like a good thing. Will have to keep a close eye on whats to come
Sarah | 12.22.15 @ 18:05
I was just talking about this to my husband, the rate increase. I know it won't be popular among those with mortgages though.
Nancy | 12.22.15 @ 18:05
We all knew it was coming. And they are still low. I'm just interested in getting a healthy economy again.
Beverly | 12.22.15 @ 18:06
We knew had to happen sooner or later. They were kept low for too long. Just glad I have a fixed mortgage and not Looking to refinance or buy anytime soon.
$commenter.renderDisplayableName() | 12.08.16 @ 04:22
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