Categories


Authors

archive Block
This is example content. Double-click here and select a page to create an index of your own content. Learn more.
A Time to Raise Rates

A Time to Raise Rates

"Electronic Data Processing and Your Credit Union” Source: http://garagesalin.blogspot.com

"Electronic Data Processing and Your Credit Union” Source: http://garagesalin.blogspot.com

By Jacob Hess

Behind the stock market, the financial giants on Wall Street, and the consumers of the American economy sits a committee of twelve: seven Federal Reserve Governors, the president of the New York Federal Reserve Bank, and four out of eleven rotating members of Reserve Bank presidents from other districts. The Federal Open Market Committee (FOMC) is the Federal Reserve’s most powerful committee. As the leaders of monetary policy in the United States, the world’s largest economy, the Federal Reserve conducts comprehensive economic analysis and responds by adjusting interest rates, buying or selling Treasuries in the bond market, or guiding markets through projections and press conferences Investors, executives, and even foreign government officials listen to what they have to say. The last meeting in September was no different. The members met, discussed the sensitive financial situation, and made their decisions. Did they make the right ones?

In order to determine whether or not the Federal Reserve acted adequately, an assessment of the current economic state is necessary. In their released notes, the Chairwoman Janet Yellen and the other Governors provide their researched estimates for various economic indicators. These, along with supplemental data, can be used to make an assessment.

The first indicator that Federal Reserve members forecast is annual change in real GDP. When this number trends higher and shows a stronger economy, the committee usually raises interest rates (the cost to borrow money) because consumers and firms can afford to pay higher interest expenses. Based on the median estimates of FOMC members, the U.S. is expected to grow at a rate of 1.8 percent in 2016 and 2.0 in 2017 and 2018. This is compared to GDP growth just above 2 percent in the early 2010’s. These projections are slightly lower than the members’ estimates from the June data, suggesting that the economy has weakened since that time. Household spending showed signs of recovering at the time, but data from July and August showed that consumers were tighter with their money. Given this update, the members would have felt more uneasy going into the September meeting, but an interest rate hike would not have been totally out of the question.

Throughout the year, the labor market has remained a strong point in the argument for a healthy economy. Since the beginning of 2015, the unemployment rate has been at or below 5 percent. FOMC members see that number dropping to about 4.5 percent over the next three years, a projection that has improved since June. According to basic monetary policy principles, the Federal Reserve increases interest rates when the labor market is at its strongest. Thus, FOMC estimates suggest that a rate hike is possible.

Because increasing interest rates reduce inflation, the Federal Reserve must wait for a sufficiently high inflation number to introduce a rate hike in order to avoid the dangers of excessive inflation or too little inflation (deflation). This monetary principle has caused FOMC members the most grief as global inflation data over the past two years has been trending near zero. Projections for 2016 inflation, though, centered around 1.3 percent which is well above 2015 numbers and approaching the committee’s target of 2.0 percent. While the Fed regards the current inflation state as low, the U.S. numbers are above average relative to the rest of the world. According to the IMF, almost 40 percent of the world’s nations is facing inflation below 1 percent and almost 20 percent is suffering from deflation, or negative inflation. Because Federal Reserve-set interest rates act as a benchmark for other countries’ monetary policy, the FOMC were wary of a weaker global expansion during the September meeting.

With this economic portrait in mid-September, the Federal Open Market Committee elected to “maintain the target range for the federal funds rate at 1/4 to 1/2 percent.” In the press release, they cited near-term risks as “roughly balanced” suggesting that they see an equal upside and downside. Once again, they promised to “closely monitor” financial developments in hopes that they can finally increase rates from their near-zero level. These near-zero levels have been in place since the Great Recession started in 2009, and many bystanders have called for a rate increase.

A Federal Open Market Committee (FOMC) meeting. Source: http://angrybearblog.com

A Federal Open Market Committee (FOMC) meeting. Source: http://angrybearblog.com

There might be evidence that some FOMC members support this call for change as, for the first time this year, three dissentions were heard. The new division within the committee was probably the most significant detail about the September meeting. Most investors assumed that interest rates would be maintained at the current level for another meeting, but none would guess that three would vote for a hike. The financial markets have responded in turn. The US Dollar Index and 10-year Treasury yield have grown 1.61 percent and 2.96 percent respectively. Both of these financial indicators usually trend in the same direction with interest. These increases show that investors are predicting that an interest rate hike will occur soon. Similarly, the S&P 500 ETF (SPY) fell about -0.2 percent after the meeting. A slight show of bearishness in the large companies that populate this index. Traders are getting the sense that it is time to raise rates, and thus, financial trends will start to point that direction through the end of 2016.

With the prospect of rising interest rates in the United States, major foreign economies are looking for a way to cope with the change in monetary policy. The European Central Bank (ECB) is probably the second most important monetary institution in the world, and will likely act in an uncoordinated manner. Economic growth for the Eurozone is trending very low, and regional stock markets are slacking just as much. An interest rate hike in U.S. markets will have a negative effect on firms in these countries as their dollar-denominated debts will increase in value. On top of that, the members of the European Union feel that Brexit will continue to mitigate any improvement in regional economic performance. For that reason, the ECB is expected to keep rates low and, perhaps, even act to push them lower even though many bond yields are already below zero.

Asia’s most advanced economy, Japan, is facing a similar problem and will most likely respond in a similar manner. The Bank of Japan (BOJ) has encouraged the stimulating effects of negative interest rates. This monetary disparity between the Federal Reserve and the BOJ has resulted in the weakening of the Japanese Yen, which is down about -1.89 percent since the September FOMC meeting. The Japanese economy is currently facing a debt crisis, with the government running up public debt to almost 200 percent of GDP. Any negative consequences from the debt problem would only be exaggerated by rising U.S. interest rates and a stronger U.S. dollar.

If rising interest rates are supposed to cause such havoc in the global financial system, then why should the Federal Reserve be considering this policy action? Looking just a couple decades ago gives us the answer. In the 1990’s, Federal Reserve Chairman Alan Greenspan dropped interest rates to below 5 percent and held them there throughout the decade. In the early 2000’s, rates dropped to below 2 percent even though the economy appeared to be healthy. These actions contradicted fundamental monetary policy which says that when the economy is weak, interest rates should decrease, but when the economy is strong, interest rates should increase. Because Greenspan allowed cheap debt to proliferate, home prices skyrocketed. More people were able to afford mortgages and, thus, added more demand to the housing market.

The current trend of low-interest rates will not necessarily produce another bubble in the housing market, but it could create other vulnerabilities in asset valuations in other markets. Nouriel Roubini, a NYU professor who warned of the 2008 housing bubble, warned in a 2013 Bloomberg interview of the existence of bubbles in European housing markets and one developing in the U.S. stock market. Three years later, he might be right. According to earnings data, the top five hundred companies in the United States have earnings that cannot keep up with their market prices. So what are investors investing in?

Up next for the FOMC board are meetings in November and December with an important presidential election wedged in between, and nobody knows how the Fed will act. Janet Yellen and her colleagues have too often found themselves trying to keep up with two financial narratives. In one, an anemic economy struggling to reach healthy inflation and corporate profit levels demands monetary stimulation through low interest rates. In the other, a historically high stock market and increasingly large mountain of debt hints at price bubbles that need to be deflated with credit tightening.

No matter the narrative, one thing is certain. The Federal Reserve needs to return to a policy of normalization, a policy framework that was abandoned eight years ago when rates were cut to near zero in order to relieve the pain of the financial crisis. Instead of slamming the brakes on a clear cyclical trend (economic expansion or contraction), central banks should accommodate the appropriate monetary response gradually and with a clear plan in mind. Too much uncertainty and spontaneity can cause negative shocks in the market, while unwinding the other direction could become tricky. If the current committee hopes to achieve some kind of normalization policy, it needs to raise rates by 0.25 percent at least once over the next two meetings. Financial markets might not appreciate the tightening and the economy may react poorly, but it must be known that this year is a time to raise rates.

Colombia’s Path Towards Peace

Colombia’s Path Towards Peace

The Role of Political Ignorance in the Creation of Insurgencies

The Role of Political Ignorance in the Creation of Insurgencies