The Fed Finally Hikes Interest Rates – Is All Well?

Federal_ReserveThe Federal Reserve concluded its meeting this past Wednesday, choosing to increase their interest rate target by a quarter of a percentage point. The move was expected by the market because the Fed had been signaling it was planning on raising rates before the end of the year. Many market participants are cheering the move, saying it shows the Fed has confidence in the economic recovery and that things will be returning to normal. However, this is quite unlikely for a number of reasons that will be discussed below.

First the facts. The Federal Reserve increased the federal funds range from 0% to 0.25% (where it had been since December of 2008), to a higher range of 0.25% to 0.50%: essentially a quarter point increase. Yellen noted that the rate increase was due to the Fed’s confidence in the U.S. economy. The Fed’s projections put interest rates at a median 1.375% by the end of 2016, implying gradual rate hikes through next year.

I previously wrote that I did not expect the Fed to raise rates this year. So yes, I was off in this prediction since the Fed did sneak in a small increase right before year end! My logic was that the Fed currently had more to lose than to gain with a rate increase, given the risk of increasing rates into a recession or pricking the stock and bond bubbles. Conversely, the Fed didn’t face much pressure to increase rates, given that inflation is currently low, and if inflation did increase, it could be blamed on other factors.

I still think that is the case, which is why the Fed’s first increase is a very small one. What may have prompted the increase could be two factors. First, since the Fed has talked about (and repeatedly delayed) increases, they may have felt it necessary to finally have one, lest they lose all credibility. It was getting to the point that the market expected it so much, that if they backed out, it could have signaled that the Fed was not at all confident in the U.S. recovery, which might have sent panic through the economy.

Second, the Fed may actually be seeing some of the recessionary data points on the horizon and, knowing we are already seven years into a theoretical recovery or expansion, they perhaps feel another recession could be around the corner. The Fed may want rates raised to give them ammunition to lower them again should a recession ensue. Not that these monetary manipulations will help prevent a recession, but it would give them some political cover to be seen to be ‘doing something.’

Some readers may be confused, thinking, “I thought rates have been too low for too long, so isn’t this a good thing?” Yes, that is correct, and this is a good thing in terms of getting rid of the easy money and credit creation that has fueled asset prices (which should be part of inflation measures, in my opinion). But there is a difference between what I think the Fed should do versus what they will actually do.

The Fed may indeed continue rate increases by around a quarter of a percentage point, perhaps at every meeting next year. Yet this doesn’t mean an end to easy money because the quarter point increases could still be too little too late. Note that a similar situation occurred before the Great Recession. The Fed hiked rates 17 times from a low of 1% in 2004 to a high of 5.25% by the middle of 2006. Yet as we saw with the housing boom, the damage of easy credit had already been done because the bubble had already been inflated. The Fed was late to take away the punchbowl then, just as I think they are late again in this instance.

What does this mean for you as an investor? The increase in rates could start to deflate some assets such as stocks or real estate, and the bond market had already been turning over even before the official rate increase. While many expected gold to decline in the face of rising rates, it has been holding steady. Also, consider that there is no historical evidence that gold always goes up or down with the Federal Funds rate.

Smart investors always ask, “What if I’m wrong?” If I am wrong, then the Fed will increase and normalize rates, as well as shrink their balance sheet. Inflation will remain low while the economy will grow nicely and unemployment will also stay low. While this is theoretically possible, it is also ‘possible’ that a golfer can make a hole-in-one 400 yards out from the green; possible, but very unlikely because every variable must align.  

This is why we consistently recommend gold as a form of wealth insurance and also a hedge, usually suggesting that physical precious metals comprise 10-20% of your portfolio. If everything turns out fine, gold will not decline significantly because we will still experience positive inflation. However, even though the Fed has now increased rates, monetary policy is still very loose, the Fed balance sheet is bloated, and the structural problems of the economy have not been solved. Gold offers you critical protection in case everything doesn’t go according to the Fed’s plan – something that history has shown to be very likely.

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.