Should the Fed Raise Interest Rates This Year?
September 16, 2015
The Federal Reserve concludes its two-day meeting on Thursday and will announce whether or not they plan to raise interest rates, specifically the Federal Funds Rate. The Fed has kept the Federal Funds Rate at zero since 2008 and hasn’t raised the rate in over a decade. Since discontinuing its Quantitative Easing (QE) program in October of 2014, the market has been obsessed with when the Fed starts to raise interest rates. This obsession makes sense as the Fed has used “forward guidance” as another monetary policy tool in recent years. However, I believe the first increase in interest rates is not nearly as important as the ultimate end to the rise in rates otherwise known as the "Neutral Federal Funds Rate." So the question remains, will the Fed raise short-term interest rates this week or even this year? Predicting changes in interest rates and monetary policy moves is virtually impossible. However, in looking at the current global economic data, I would caution the Fed not to raise interest rates in 2015.
The Case For and Against Raising Interest Rates
Some Fed governors and market participants want the Fed to raise rates simply so we can get off of 0%. Some argue 0% is an “emergency” level of interest rates and our economy no longer justifies “emergency” levels. Others argue that positive, albeit low, economic growth along with a low unemployment rate should point the Fed to raise rates now. Finally others argue to get off zero would allow for a more efficient bond market. In my opinion, the reasons to raise now are heavily outnumbered by the reasons to wait. In his most recent webcast, Jeffrey Gundlach laid out reasons not to raise interest rates now:
- Both the World Bank and the IMF have cautioned the Fed not to raise interest rates too soon.
- Very low nominal GDP growth compared to historic beginnings of Fed policy hikes.
- A large drop in commodity prices.
- Weak credit conditions seen through a weak junk bond market.
- Weak growth in emerging market economics which has caused a decline in emerging market equities and currencies.
- Inflation and future inflation expectations well below the Fed’s 2% target.
- A precipitous drop in oil prices.
- Improving, but still weak, US wage growth.
- A strong dollar.
- Decelerating manufacturing growth.
- Declining sales (year over year) from S&P 500 companies.
Gundlach said in a normal economic cycle, the current global economic data points to Fed easing rather than Fed tightening. If the Fed does not raise rates tomorrow, I believe the first increase will then be pushed into 2016. If the Fed does not raise rates in September, why would they just a month later? The next opportunity would then be December which historically is a month in which the bond market is very illiquid. I don’t believe the Fed wants to embark on raising interest rates until the time is optimal and December would not be optimal.
Escape from a Liquidity Trap
The Federal Funds rate affects a myriad of market participants from large commercial banks, to bond managers, to hedge funds, to your own deposit rate at your bank, which most likely is 0%! The Fed’s actions also have a very powerful effect on the global financial system. Think back to the depths of the global financial crisis in 2009 in which we were suffering from a severe case of a “liquidity trap”. A liquidity trap is a situation in which monetary policy (increase in money supply) has no effect on increasing interest rates, income and does not stimulate economic growth. Put another way, the world was in shock, so the private sector responded by sticking its head in the sand and decreasing debt in what’s commonly known as deleveraging. This deleveraging has continued over the past 6 years. The classic Keynesian response to a liquidity trap is to ramp up fiscal policy; cut taxes, increase government spending etc. But the constant unwillingness of politicians to get anything done on the fiscal side shifted the burden to the Federal Reserve.
Emerging from Zero
Forward guidance is a new tool the Fed has employed in recent years. As the Fed engaged in QE, there was no chance or even a discussion surrounding raising interest rates. As Paul McCulley has said,
"The bond market is nothing more than a forward curve on expected Fed policy plus a risk premium.”
In other words, think of the Federal Funds Rate as a rough proxy for a return on cash, currently 0%. Long term interest rates are in a sense “pulled down” by a 0% policy rate as the risk premium one assumes on a long bond is low in a zero-bound world. Assuming a PIMCO “New Neutral” world, the Fed’s Neutral policy rate should be closer 2% than 4%. Adding a risk premium in our new neutral world for bonds and stocks then only gets us to maybe a 3% return for bonds and 5% return for stocks. I’m certainly not trying to predict future market returns here, but I do want to point out the enormous effect the Fed has on all markets! The emergence from 0% is an important moment. Much more important however, is the ultimate end point to the Fed’s tightening cycle as the Neutral Fed Funds Rate affects everything from deposit rates on cash in the bank, to mortgage rates, insurance premiums, and returns on stocks and bonds. Arguments can be made on both sides and the chances of an increase in interest rates this year is virtually 50/50. Bottom line, the Fed should wait and start to raise interest rates when global economic conditions are much more favorable.
The Economic Times – “Definition of “Liquidity Trap” Available online at economictimes.com
DoubleLine Funds Webcast 9/8/2015 – “In Our Time”