Way back in July, Federal Reserve Chair Janet Yellen said: “I expect that it will be appropriate at some point later this year to take the first step to raise the federal funds rate and thus begin normalizing monetary policy.” Well, later this year is here. There are only three Fed policy meetings left in 2015, starting with the two-day confab beginning on Wednesday and concluding Thursday. After delivering that speech, the consensus was that the Fed would increase rates at the September meeting, but a funny thing happened over the past two months: China’s stock market plummeted, raising fears that the economy there had slowed down dramatically; raw commodity prices plunged, which has put global disinflation (a period when the inflation rate is positive, but declining over time) on the front burner; and global stock and currency markets entered a new, tumultuous phase.
All of the sudden, the September rate hike now looks less likely. In fact, traders now only see a 25 percent chance that the Fed will act this week. Of course, Yellen has always kept her options open. In that same speech, she said “I want to emphasize that the course of the economy and inflation remains highly uncertain, and unanticipated developments could delay or accelerate this first step.”
Economists and investors have long been agonizing over the timing of the Fed’s rate hike. Those who advocate action cite the improvement in the U.S. economy: 13.1 million jobs over the past 66 months and unemployment at 5.1 percent, which is lower than the levels seen at the beginning of the Fed’s last tightening cycle in 2004; auto sales running at their fastest pace in a decade; commercial real estate prices surpassing their bubble-era peaks; and residential housing strengthening. That impressive list of accomplishments makes it tough to justify interest rates still being at emergency levels of 0-0.25 percent, which is where they have been since December 2008.
Former Treasury Secretary Larry Summers is the cheerleader for the no-action camp. Last week, he said “Now is the time for the Fed to do what is often hardest for policymakers. Stand still.” Besides global uncertainty, Summers reminds us that part of the Fed’s dual mandate is to promote price stability and with disinflation infecting emerging markets and U.S. core inflation remaining stubbornly low, he is advocating that the Fed do nothing at this time.
All of this may seem like navel-gazing to you, but if the Fed is too late in raising rates, inflation might rise. According to Paul Ashworth of Capital Economics, “Historically, central banks have mostly erred on the side of raising interest rates too little and too late. The result is that inflation starts to spiral out of control, eventually forcing a more aggressive tightening of policy than would originally have sufficed.”
Then again, if the Fed acts too quickly, it could snuff out the recovery. Andrew Haldane, the Chief Economist at the Bank of England has noted, “The act of raising the yield curve would itself increase the probability of recession.”
WHAT DOES ALL OF THIS HAVE TO DO WITH YOU?
In the seven years since financial crisis, companies, governments and consumers have gotten used to ultra-low interest rates. Whether the Fed decides to increase rates this week, in October or in December, the low rate cycle is about to conclude. Here’s how it could impact you:
Savers: Any increase in the Fed Funds rate will help nudge up rates on savings accounts, so savers will finally be rewarded. That said, rates will still be low and the likely slow pace of increases will mean that savers’ suffering is not likely to end any time soon.
Borrowers: While rates for mortgages key off the 10-year government bond, adjustable rates are linked to shorter-term rates, which means that consumers should be careful about assuming these loans and also should consider locking in a fixed rate now. Additionally, as rates increase, the availability of 0 percent credit card and auto loans could diminish.
Investors: Typically, stock markets have dipped after the first rate increase, but usually regain their upward momentum, as long as the rate increase is in response to stronger economic activity. Stocks usually top out after the final increase. The last tightening cycle began with interest rates at 1 percent in June 2004 and ended with rates at 5.25 percent two years later. The stock market peaked in October 2007 and you know what happened after that!
Finally, billions of dollars have flowed into global bond markets over the past seven years, as nervous investors sought the safety of fixed income. While few are advocating selling out bond positions, to help protect your portfolio against the eventual rise in interest rates, you may want to consider lowering your duration, using corporate bonds and keeping extra cash on hand. (For more on bonds, check out this post.)
- DJIA: 16,433 up 2% on week, down 7.8% YTD
- S&P 500: 1,961 up 2.1% on week, down 4.7% YTD
- NASDAQ: 4,822 up 3% on week, up 1.8% YTD
- Russell 2000: 1157, up 1.8% on week, down 3.9% YTD
- 10-Year Treasury yield: 2.19% (from 2.13% a week ago)
- October Crude: $44.81, down 3.1% on week
- December Gold: $1,107, down 1.6% on week
- AAA Nat'l avg. for gallon of reg. gas: $2.35 (from $2.40 wk ago, $3.41 a year ago)
THE WEEK AHEAD:
8:30 Retail Sales
8:30 Empire State Manufacturing
9:15 Industrial Production
10:00 Business Inventories
8:30 Consumer Price Index
10:00 Housing Market Index
Thurs 9/17: 8:30 Housing Starts
2:00 FOMC Decision/Econ Projections
2:30 Yellen Presser
10:00 Leading Econ Indicators