What factors might influence the Fed in the near future?

 Presented by Marc Aarons @ Money Managers Inc.

Here’s a trivia question for you: when was the last time the Federal Reserve raised the benchmark U.S. interest rate?

The answer: June 29, 2006. On that day, the federal funds rate hit 5.25%. It has declined ever since, and it has stayed at 0%-0.25% since December 16, 2008. The Fed expects to hold interest rates at 0%-0.25% through late 2014, and some analysts think they will remain there into 2015.^1,2

All that noted … when should the Fed make a move with rates, and what might happen when rates approach something like historical norms?

Right now, the Fed has little incentive to make any moves. Our economy generated only 75,000 new jobs per month in the second quarter of 2012 compared to 226,000 a month in the first quarter. Unemployment is currently at 8.2% and we have housing and business sectors that are far from healed. Hiking the federal funds rate in such an environment would seem nonsensical. In fact, the Fed’s rationale for its current policy is that interest rates need to stay at or near these levels until we reach full employment (a 5-6% jobless rate). Low interest rates help to encourage business investment and big-ticket purchases, though they are no boon to retirees.³

Does the economy warrant further easing? Maybe not. The federal government’s second estimate of Q2 GDP (+1.5%) exceeded the +1.2% consensus forecast of economists polled by Briefing.com. That might signal the Fed to hold off on QE3.⁴

When might rates rise? It might be a while. Right now, we have very mild inflation: as of June, the Consumer Price Index was up just 1.7% across the past 12 months, within the Fed’s target. Demand for capital isn’t what it was before the recession, encouraging lenders to stay competitive. The Fed, the Bank of Japan and the European Central Bank have all printed more money, which encourages low interest rates in the short term.⁵

Of course, bloating the money supply might stimulate inflation in the long run. Some see greater inflation on the horizon: a June Pimco analysis forecast inflation rates rising during the next 3-5 years, citing shifts in exchange rates and rising commodity prices as potential drivers. Earlier this year, Slate founder and Bloomberg View columnist Michael Kinsley warned of “a fierce storm of inflation sometime in the next few years” that will “wipe out a big chunk of the national debt, along with the debts of individual citizens, and the savings of others.”^6,7

Few economists feel that America is risking hyperinflation. Most see tame consumer inflation for years ahead, and the Congressional Budget Office’s 2012 edition of its Budget and Economic Outlook forecasts the government’s PCE price index advancing no more than 2.0% annually through 2022. Yet policymakers have been stung by macroeconomic forces before … and it may happen again.⁸

What will bond investors do if they climb? If interest rates kick up, what investor will want to be stuck with a 1-2% TIPS return? He or she may end up selling that Treasury at market value. Think back to the 1970s, when long-term bond investors lent the government their money at 5-6%, then saw inflation go from 2-3% to almost 13%. This is a historically extreme example, but worth noting. If the federal funds rate rises 3%, a longer-term Treasury might lose as much as a third of its market value as a consequence. On June 12, 2007, the yield on the 10-year note was at 5.26%.⁹

On the other hand, another argument is that Treasury yields could be low for years. More than a few economists see a well-worn path from eras of easy credit and poor lending practices to excessive debt, then asset bubbles, then sustained economic slumps with minimal yields on long-term bonds.

You don’t have to go back too far to find paybacks for years of high total public debt. Besides the credit crunch and downturn of 2007-09, you have the current examples of Greece, Italy, Spain, Ireland and France, the Latin American debt crisis of the early 1980s (with Mexico’s default), Japan’s 1989-90 crisis and our own Great Depression.

Why make money a little less cheap? Raising interest rates in the near future could actually accomplish some objectives. It could help to improve retiree income and retirement savings potential. It could encourage banks to loosen reins on their excess reserves. It could prompt those uncertain about homebuying to take the plunge.

Are the stock and commodities markets ready for an interest rate hike? Maybe not, but some notable voices – among them St. Louis Fed President James Bullard, Richmond Fed President Jeffrey Lacker and Charles Schwab – have publicly made the case for a rate hike before the jobless rate returns to normal levels. Should the economy heal at a faster pace, the federal funds rate might move north sooner than we think.^10,11

Marc Aarons is a Representative with Money Managers Inc. and may be reached at www.ocmoneymanagers.com, 714-887-8000 or Marc@ocmoneymanagers.com.

Citations.

1 – www.newyorkfed.org/markets/statistics/dlyrates/fedrate.html/ [7/30/12]

2 – online.wsj.com/article/BT-CO-20120730-709627.html [7/30/12]

3 – www.nj.com/news/index.ssf/2012/07/us_unemployment_rate_stays_at.html [7/6/12]

4 – briefing.com/investor/calendars/economic/2012/7/27 [7/30/12]

5 – www.reuters.com/article/2012/07/17/us-usa-economy-prices-idUSBRE86G0IQ20120717 [7/17/12]

6 – www.marketwatch.com/story/pimco-sees-rising-inflation-for-3-5-years-2011-06-27 [6/27/12]

7 – www.bloomberg.com/news/2012-01-20/about-rising-inflation-please-remain-worried-michael-kinsley.html [1/20/12]

8 – www.cbo.gov/sites/default/files/cbofiles/attachments/01-31-2012_Outlook.pdf [1/31/12]

9 – www.treasury.gov/resource-center/data-chart-center/interest-rates/Pages/TextView.aspx?data=yieldAll [6/6/12]

10 – www.reuters.com/article/2012/02/06/us-usa-fed-bullard-idUSTRE8121QG20120206 [2/6/12]

11 – blogs.wsj.com/economics/2012/05/01/feds-lacker-higher-interest-rates-could-be-needed-even-if-jobless-rate-doesnt-fall/ [5/1/12]

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