The Federal Reserve and FOMC concluded their two day meeting on Wednesday and announced they would be keeping interest rates near zero. This was expected, of course. What is causing anxiety for market participants is the continued question of when the rate hike cycle will actually start. Today’s decision continues to drag out the anticipation and fuel the debate. In this article, we will first look at the facts of today’s announcement and then analyze the options the Fed is currently facing and the implications for the markets.
Although a rate hike was technically possible, almost all pundits and economists knew that was not going to happen. Instead, the main focus was on any indications by Fed chairwoman Janet Yellen concerning when or if rate hikes would be coming later this year. In this regard, it seems the Fed in their prepared remarks, as well as during the Q&A session, gave the impression that although rate hikes may start this September or December, they would be very slow and deliberate.
The Fed also reaffirmed that they would continue to roll over securities on the Fed’s balance sheet, keeping it from shrinking which in turn also retains their accommodative stance. The Committee also noted that “economic conditions may, for some time, warrant keeping the target federal funds rate below levels the Committee views as normal in the longer run.”
If we look at the Fed’s “dot-plot,” we can indeed see that 15 of the 17 Committee Members are forecasting at least some kind of rate hike this year. However, it should be noted that these “dots,” or forecasts, have been lowered again, this time around.
We can turn to the markets to see how participants actually interpreted the news; stocks were declining slightly during the day and then they popped on the announcement, ending the day in slightly positive territory (up approximately 0.20%.) The dollar declined slightly, and gold jumped a little on the announcement as well. Both of these indications confirm that the market believes the Fed will continue to be accommodative; if they believed a sharp rate increase were coming, the dollar would have rallied.
Personally, I do not believe the Federal Reserve will hike rates this year at all or, if they do, it will be incredibly small and incremental. To explain why, look at the options a central banker faces. If the Fed raises rates too early and the economy can’t handle it and falters or the markets drop, the blame will be placed squarely on the Fed. But if the Fed errs on the side of keeping monetary policy too loose, the worst that will happen will be continued financial asset or price inflation, both of which have a delayed effect. Further, even if price inflation goes beyond 2%, the Fed can easily blame this on other factors or deem it as ‘temporary’.
What few people are talking about is that the Fed has lowered their GDP forecasts for this year again, down to only 1.8-2.0%, hardly a robust economy that previously has averaged GDP growth of at least 3.0% per year. This comes after the first quarter of this year showed that the economy contracted by -0.7%. While the Fed likes to write this off as ‘transitory’, we have seen further deterioration in other economic data points since then.
Therefore, if another recession (or at least lower or even negative GDP growth) is around the corner, the Fed will be reluctant to increase rates. Knowing this, the Fed faces two options to try to maintain credibility. The first is to talk tough about raising rates, but never actually raise them for fear of derailing the economy or financial markets. The second is to start raising rates ever so slightly but, at the first sign of trouble, reverse and lower them again. This would give them breathing space to tackle a slowdown, rather than being stuck at zero.
If you believe the Fed has committed to raising rates and everyone else is counting on it, let’s not forget that it was previously forecasted by many economists last year and even early this year that there was a good chance we would see a rate hike at this June meeting. The Fed continues to claim they will be ‘data dependent’, but the metrics they use can easily be changed. Recall that they previously said they would look to raise rates once unemployment dropped to 6.5%; it is now at 5.5% and rates still haven’t budged.
Finally, another factor pressuring the Fed to keep rates down is that other central banks around the world are actually easing, namely Japan and Europe. The IMF even called on the Fed not to raise rates until 2016 for fear of what it could do to global markets. If the Fed raises rates while the rest of the world continues to ease, the dollar would rally and make it harder for the U.S. to export goods, which in turn would drag down GDP.
In conclusion, the Fed continues to be painted in a corner. Its easy money policies have continued for almost seven years now, propping up the economy and financial markets, but it now faces the uncomfortable decision of how to exit this support. If the accommodative stance continues, expect financial assets to continue to do well and other hard assets like gold to be attractive.
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.