Chief Investment Officer, City National Rochdale
The big day has finally arrived. On Thursday, the Federal Open Market Committee will announce its decision on raising short-term interest rates for the first time since 2008. The hand-wringing over the timing of Fed Chairwoman Janet Yellen’s plans for beginning the rate normalization process has consumed the financial press for many months now. While the need for higher rates is not in question, the timing of the first move has many investors on edge. At the end of the day, is all the anxiety over a possible one-quarter percent increase in short-term interest rates really justified?
As the world’s reserve currency, interest rate differentials between the U.S. and the rest of the world play directly into the value of the U.S. dollar, and can have important effects on capital flows between countries, the ability for corporations to service their debt, and the cost of commodities (not to mention U.S. economic growth). There are an uncountable number of borrowers, lenders, and savers whose financial fortunes will be affected by the Fed’s decisions in the coming months. So any decision by the Fed to raise the cost of borrowing, however small, should not be dismissed.
But the daily back-and-forth over the timing of the “liftoff” seems grossly exaggerated. Whether the first increase comes in September, later in 2015, or even early 2016 has little to do with the performance of financial assets over the next few years. What is more important is the pace at which the Fed raises rates and its ultimate target end point. At this point, the market expects fed funds to have risen to only about 1.5% by the end of 2017. That would be a very gradual rise and probably a path that would be supportive for financial assets.
The debate over the timing is centered on several key data points. At 5.1%, the unemployment rate is low enough to argue that the job market is near full employment, which is one of the mandates that the Fed is charged with pursuing. On that basis, one might contend that a near-zero rate policy is no longer necessary. The other mandate is price stability, as defined by the Fed’s inflation target of 2%. Inflation has been running well below the Fed’s target for several years now, so the danger is that higher rates could drive inflation down even further, and slow the U.S. economy’s already-sluggish growth rate. The Fed has never raised rates with inflation at this low a level.
It is well known that the Fed wants to get interest rates up so that they have more tools at their disposal to stimulate the economy in the next downturn. However, recent market skittishness has some observers worried about the impact of a September move on investor confidence. Tough to say how much the market volatility will have on the Fed’s decision.
It is hard to predict the market’s reaction to the Fed announcement on Thursday. If they do raise rates but reiterate or lower their plans for slow increases from here, stocks could rally. They would be sending a message of confidence to the markets. If they hold off, we can expect more conjecture and uncertainty about what’s next. And as we know, markets hate uncertainty.
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