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When Will Rates Rise?

| January 08, 2015
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By Nick Hughes

When will the Federal Reserve begin to raise the federal funds rate? It’s a question that may affect U.S. markets more than any other during 2015. Last fall, Chicago Fed President Charles Evans noted:1

“…Monetary policy does not presently face a conflict in goals; actions that support employment growth also help move inflation up toward our target. Yet, as I look to the future and assess risks, I foresee a time when a policy dilemma might emerge: Namely, we could find ourselves in a situation in which the progress or risks to one of our goals dictate a tightening of policy while the achievement of the other goal calls for maintaining strong accommodation.”

In other words, improved employment data may signal the need for tighter monetary policy, but stubbornly low inflation may suggest a different course of action.

A Look Back
Following the financial crisis, the Fed cut the fed funds rate, which is the overnight rate at which banks lend to one another, to nearly zero. It also initiated several rounds of quantitative easing (QE), an unconventional monetary policy that had the Fed buying government securities to encourage low rates and keep money readily available to those who needed it. The Fed’s third round of QE ended in October 2014.2

The end of QE left the Fed’s balance sheet, an accounting of what it owns and what it owes, looking considerably different than it did back in 2007. Today’s balance sheet is much larger. Total assets had grown from $869 billion to more than $4 trillion late in 2014.3 The nature of the assets and liabilities held had changed, too. The new balance sheet was loaded with long-term Treasury and mortgage-backed securities.4

The plan is to reduce these holdings gradually once the next step on the road to ‘normalizing’ monetary policy – namely, raising the Fed funds rate – has been taken. Raising the rate will push banks’ borrowing costs higher. They, in turn, will charge consumers and businesses higher interest rates on mortgages, credit cards, and loans.5

Timing is everything
According to The New York Times, a number of Fed officials have endorsed the idea of raising rates in mid-2015; some want to act sooner, and some prefer to wait longer.6

Here are a few data points markets, economists, and Fed officials may consider as they think about rate hikes:

• Employment. More people are finding jobs and more people are leaving jobs for better opportunities; however, The New York Times reported there is still “evidence of considerable slack including the unusually large number of part-time workers who say they cannot find full-time work.”6
• Inflation and energy prices. Lower energy prices have given the American economy a multi-billion dollar boost, according to The New York Times, and helped keep inflation low.7 However, The Wall Street Journal pointed out, “Some economists say [low inflation] is the biggest problem facing the global economy as it enters 2015, and will likely lead to further stimulus efforts by a number of central banks, while others will wait longer to raise their benchmark interest rates from unusually low levels.”8
• America’s economic health.The Economist recently presented narratives that may fit what it called, a “strange, strange set of data points” in the United States. “Things are clearly still amiss in America when monetary policy can remain so far from normal while the economy revs up even as inflation and wage growth limp along at pitifully low levels.”9
• Monetary policy outside the United States. Late in 2014, central banks in Japan and Europe announced they would implement quantitative easing. China’s central bank lowered rates. According to Barron’s, these policies, “…put pressure on the yen and euro which drives up the dollar and drives down U.S. inflation… The Fed would like to see more inflation. And, that’s why, if no one else is on the road to normal policy, it’s awfully hard for the Fed to continue along the road to raising rates.”10
• The Great Depression. In 1937, in response to positive economic growth and re-inflation, the Fed tightened monetary policy and the economy spiraled into recession and deflation. Fed president Charles Evans has said he believes the biggest risk our economy faces today is the Fed prematurely engineering restrictive monetary conditions.1

Barron’s has said there is little doubt the Fed wants to raise interest rates. The trick is acting in a timely way so rate hikes don’t halt the momentum of the U.S. economy.11 Stock and bond investors will wait with bated breath while the Fed reads the economic tea leaves and determines a course of action. It’s no secret speculation sometimes makes investors antsy, so it’s possible markets could be bouncy until rate hikes become a reality.

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