Federal Reserve interest rates present potential risk in the long-term

Federal Reserve interest rates present potential risk in the long-term

The Federal Reserve held rates steady last week and Wall Street cheered, but the reasons for the Fed’s hesitancy may represent significant risks for investors down the road.

In the last policy meeting of 2015, the United States Federal Reserve raised interest rates for the first time in more than seven years. The accompanying forecast from the world’s most important central bank described intentions to continue tightening monetary policy, including a ‘Dot-Plot’ illustrating at least four additional raises through the end of 2016, dependent upon key economic data points.

After an historic rout in US and global markets over the first six weeks of the New Year, indices had recovered the vast majority of losses leading into the first Federal Open Market Committee (FOMC) meeting of 2016.

Futures markets predicted a 0% chance of an interest rate hike at the March FOMC meeting and they were proven correct – the Fed announced it would hold base interest rates steady at 0.25%-0.50%, and lowered its target rates for 2017 by 50 basis points.

However, even though current rates remained the same, the announcement was not without surprise.

The announcement included a revised forecast for the number of rate hikes investors could expect through the remainder of the year. Instead of the four additional 2016 rate hikes anticipated in the December 2015 policy statement, last week’s policy statement backpedaled significantly as it indicated that it now plans on only two rate hikes by the end of the year.

The surprisingly dovish tone was cheered on Wall Street.

Fewer rate hikes equals a more accommodative monetary policy that tempers concerns of diverging stances of central banks, the headwinds brought on by a strong dollar, and possible disruptions caused my raising rates too far, too fast.

After the announcement, both the Dow Jones Index and S&P 500 rallied into positive territory for the first time this year, having recovered from 10%+ losses a little over a month before.

A different kind of divergence

In early 2016, diverging policies of the world’s central banks had worried investors as the Fed pursued a tightening monetary policy in contrast to the easing policies of the European Central Bank (ECB) and the Bank of Japan (BOJ).

While the ECB and BOJ have continued easing – Japan taking rates negative for the first time in their history, and Europe pushing rates further into negative territory – the Federal Reserve’s apparent change of heart gives investors the impression that the gap between policies may be closing. Thus the correlated risks associated with that gap necessarily subside as well.

But with the recent course correction the Federal Reserve creates a divergence of a different kind; abandoning fidelity to a data-dependent decision-making process for one that is merely amenable to market sentiment alone.

For months, if not years, the Federal Reserve has stated interest rate hikes would be conditional upon stable employment figures and achieving inflation goals approaching 2% annually.

Currently, official unemployment figures stand at 4.9%, a level historically regarded as full or healthy employment.

Moreover, the Core Consumer Price Index (Core CPI) exceeded the Fed’s conditional levels, reaching an annualized rate of 2.3% in the latest reading.

Alas, the Fed did not follow through on the data-dependent commitment, and this infidelity to forward guidance poses its own unique risk.

At a time when central banks are rapidly exhausting their policy ammunition, maintaining investor confidence is paramount.  That confidence becomes increasingly hard to keep when policy directives are abandoned quarter to quarter.

Global interdependency

Regarding the decision, the FOMC stated that risks from global economic and financial developments were a contributing factor. Considering the fact that explicitly stated domestic employment and inflation targets have been met, one must surmise that global conditions were indeed the primary motivator.

Those developments consist of the deteriorating health of Eurozone banks, alarming declines in Asian economic indicators, and the persistent failure of evermore accommodative policies across the world to have the desired economic effects.

Perhaps more important, though unstated, is the devastating aftermath suffered by global markets when the Fed initiated the policy divergence in the first place.

Global economic and financial conditions have arguably worsened since December 2015 and as previously mentioned international monetary policy has eased as a result.

Raising US rates further against a backdrop of falling/negative rates abroad, may, in the Fed’s view, risk another painful capital markets contraction that only exacerbates economic weaknesses.  Such a negative feedback loop is exactly what central bankers would like to avoid.

Failure to launch

More than mere technical divergences and weak economic numbers, the more worrisome undercurrent of political risk that has increasingly bubbled up to the surface in the last six months is emotional in nature.

Particularly in Europe, years of ‘no holds barred’ monetary stimulus, best represented by ECB President Draghi’s ‘Whatever it takes’ promise, has failed to yield desired results.

This phenomenon, referred to by famed economist John Maynard Keynes as ‘pushing on a string’, has the unwelcome effect of eroding confidence in the efficacy of central banks in general.

The entirety of the post-WWII global financial system depends on this confidence.

Thus the Fed is likely to exhibit more fealty to this sentimental foundation of monetary policy, than it is to its own guidance going forward.

The problem, of course, is that emotions often run wild when money is on the line, and even the most aggressive actions to protect the world’s financial foundation may merely be ‘pushing on a string.’

Categories: Economics, North America

About Author

Jeffrey Moore

Jeff Moore is a Project Manager and Research Specialist with the North Carolina Department of Commerce, with a focus on legislative, economic and workforce issues. Previously, he served in the Office of Governor Pat McCrory as an economic policy aide and researcher. After earning a BA in Political Science from the University of North Carolina at Chapel Hill in 2007, Jeff worked as a proprietary equity trader, successfully navigating capital markets during the 2008 financial crisis and the ensuing business and political ramifications that followed.