Fed Caves to Pressure, Leaves Rates Unchanged

Pressure gaugeThe Federal Reserve concluded their two-day meeting on Thursday, announcing that rates will remain unchanged. Traders and investors were not expecting a rate increase, so the announcement was no surprise. Although for some time now the Fed has been hinting at starting on a path of increasing rates, Thursday’s announcement actually shows they are not likely to start this anytime soon, with more excuses ‘not to raise’ being added to the list.

The Fed has been talking a big game this past year of getting interest rates back to more normal levels, since they have been near zero since December of 2008 (almost seven years ago!). Therefore, it was previously thought that by the end of 2015, the Fed would start raising rates and that this September meeting – or at the very latest, December – would be the start of rate increases.

But as I have previously noted, the Fed has everything to lose and not much to gain by raising rates. Their preferred measure of inflation is still low, below their 2% target level, and the economic ‘recovery’ has continued to look pretty weak. So if they raise rates, they risk crashing the economy in the near-term and getting all of the blame. Leaving rates low will cause asset inflation, or maybe even price inflation eventually, but this won’t happen until much later, at which time those things can be blamed on a host of other factors.

While the Fed likes to say they are data-dependent, pretending they are completely objective, it is obvious their decisions on interest rates are completely discretionary and largely arbitrary. With unemployment now at 5.1%, we were supposed to have had rising interest rates long ago, but the Fed abandoned those guideposts, and it became clear they didn’t want to raise rates yet.

The Fed has added another factor they can use to delay further rate increases: global economic and financial developments. The WSJ has a tool that compares the Fed’s latest statement with their last one in June, so we can see they have now added the following lines (in italics):

Recent global economic and financial developments may restrain economic activity somewhat and are likely to put further downward pressure on inflation in the near term. The Committee continues to see risks to the outlook for economic activity and the labor market as nearly balanced, but is monitoring developments abroad.

In other words, the Fed isn’t just looking at the dual mandate of employment and inflation, but is increasingly factoring into their decision-making global economic activity. This shouldn’t come as a surprise, as we previously noted how the Fed is being pressured by other central banks and the IMF to hold off on raising rates. Europe and Japan continue to struggle, so the Fed increasing rates would create a divergence in policy.

The ongoing currency wars are related to this. If the Fed raises rates, it strengthens the dollar and makes U.S. exports more expensive, causing a drag on GDP since one of its components is net exports. A stronger dollar also means cheaper imports, which lowers inflation; it is a good thing for consumers, but a bad move in the eyes of a Fed that wants 2% inflation.

Investors should therefore expect low rates to continue into next year or perhaps even beyond. The futures markets show investors are already expecting this; before the Thursday meeting, they were only attaching a 27% probability to a rate increase. The market was previously putting a 64% probability on an increase by December, but after the Fed’s comments on Thursday this as been lowered to a 45% probability.

I think investors are right. In fact, the Fed’s dot-plot – which shows what FOMC members see for appropriate rates in the future – is now showing that one member thinks the appropriate policy is to have negative nominal rates in 2015 and 2016!

So what’s the end game here? We know monetary policy cannot create wealth or stimulate sustainable economic activity. But the Fed will continue to think it does, so it will continue to provide easy money, perhaps even restarting quantitative easing. It’s possible that inflation, as measured by consumer prices, could rise above 2%, at which time the Fed will hopefully have some integrity and stop the easy money. But we could just as easily go into another recession (because monetary policy doesn’t prevent those from regularly occurring), bringing about lots of deflation and giving the Fed even more ammunition to continue to print money.

It’s is a fool’s game to try to guess which scenario will occur. Instead, focus on being prepared for both scenarios – owning precious metals as an inflation hedge as well as having investments in high-quality companies and global businesses. Above all, continue to invest in your own skills and education – the ultimate resource!

Chris Kuiper, CFA is currently a student and researcher at George Mason University, pursuing a Master’s of Economics. His previous experience includes asset management, investing and banking.