By Raymond Michaels – raymond.michaels@internationalbanker.com
The US federal funds rate, which represents the cost of overnight loans in the interbank market, is under the spotlight. Now with projections in place that the federal funds rate will rise in 2015 for the first time since 2006, the debate is more heated than ever about an expected change to official guidance on the timing of rate rises.
The Federal Reserve’s key interest rate, the federal funds rate, has been close to zero since the financial crisis in 2008. The Fed is tasked with setting interest rates in the US, and this economic parameter has a wide impact that is felt all over the globe. Market participants, economic spectators and other relevant parties across the world are wondering when interest rates will rise and how fast? With interest rates in the US being determined by the Federal Open Market Committee, which consists of seven members of the Federal Reserve Board and five of the twelve Federal Reserve Bank presidents, the Federal Reserve’s decision will have the greatest impact on the economic consequences of its rate-setting policy. The formal comments and statements provided by the Federal Reserve’s chairperson and officials have indicated a sentiment toward raising interest rates sooner than originally planned. The Fed has announced reductions in bond purchases at a speedier rate than originally outlined, indicating that the US economy is strengthening at a faster pace according to the Fed’s analysis and indicators. Federal Reserve officials recently agreed, at their June policy meeting, to end their bond-buying programme during October of this year.
The central bank has reduced monthly bond purchases by $10-billion increments throughout 2014, from a peak of $85 billion. The preliminary plan to end the bond-buying programme outlined in the minutes of June’s meeting indicated the Fed’s intentions to reduce bond purchases in increments at its subsequent three policy meetings, including a $15-billion reduction in October, leaving no bond purchases for November 2014. This meeting of Fed officials took place before economic indicators were released that reported strong job growth in June. However, the economic figures also demonstrated that an even larger economic contraction occurred in the first quarter of 2014 than was expected. This peculiar and unexpected mix of declining unemployment during a period of mediocre growth is one of many conundrums with which Fed officials are now grappling. Although there are elements of economic growth and strength, overall the uncertainty regarding the stability of growth means that the timing of rate hikes remains under debate.
Following the global financial crisis, the Fed initially announced its first round of bond purchases— launching successive rounds of purchases in 2010, 2011 and 2012, each time adding to the programme in attempts to counteract economic underperformance. The Fed’s total holdings of bonds, loans and assets has built up from under $900 billion to $4.4 trillion as part of quantitative easing. The announcement of the decision to end the latest round of bond purchases therefore marks a monumental step for the central bank.
The continued tapering of bond purchases was not a surprise to market and economic participants. However, what was unexpected was the decision of Fed Chair Janet Yellen and the Federal Open Market Committee (FOMC) to eliminate the longstanding 6.5-percent unemployment target for raising interest rates, which had previously come to be known as the “Evans Rule”. Although the Fed has never specifically stated the details of the so-called Evans Rule, the gist of the rule has been discussed numerous times and has been identified as a warning indication level for safeguarding against inflation. The FOMC attempted to replace the terms of the Evans Rule by instead emphasizing other economic parameters—what it has stated as “a wide range of information” in making economic-policy decisions. The FOMC has also announced, somewhat vaguely, that the committee will be monitoring “readings on financial developments”.
Under the leadership of former Chairman Ben Bernanke, the Fed set into place measures to encourage transparency and clarity, so this step in a more vague direction has come as quite a surprise. Bernanke’s chairmanship set in place a system based on indicators, and this substitution of less well-defined information marks a transition away from using specifically defined statistics in making decisions and setting economic policy. Market participants have been a little flummoxed by this change in Fed direction—especially after having become dependent on clear milestone markers to highlight the direction of the Fed and the forecasted future of the economy. Keeping tabs on an undefined concept of “financial developments” is much trickier than a numeric unemployment level when trying to ascertain when a rate hike will be on the agenda. Reflecting this uncertainty in the wider market behaviour, equity markets saw significant falls after the so-called Evans Rule was officially discarded by the Fed.
FOMC participants have raised their short-term interest rate projections from 0.75 percent by the end of 2015 to 1.0 percent. Though this increase is not excessively large, it was a move the markets did not expect, with a significant sell-off in equities ensuing soon after the announcement. The 2016 forecast has also been raised from the previously indicated 1.75 percent level to 2.25 percent. These changes indicate a change in the FOMC’s economic assessment. Soon after the announcement to end bond purchases altogether, Fed’s Chair Janet Yellen stated, during a press conference, that the removal of the 6.5-percent unemployment level as a signal to raise rates did not indicate a change in policy direction and intention. However, she did not make any clear statement as to how long after bond purchases end that interest rates would remain suppressed. Investors remain uncertain and speculative about interest-rate forecasts. Yellen did, however, comment that the federal funds rate may start to rise approximately six months after the end of the bond-purchasing programme – although the implications remained vague.
The US economy has recently reported data indicators that have demonstrated that an expansion has been occurring at the fastest rate in nearly three years; second-quarter figures have fuelled expectations that the Federal Reserve may begin to raise interest rates prior to mid-2015. The US economy has reported growth in activity on a broad basis and is therefore feeding hopes of a sustainable and stable recovery. Consumer spending, accounting for more than two-thirds of US economic output, increased by 2.5 percent in the second quarter of 2014, while business-equipment investment rose by 11.2 percent over the same period. Unemployment has most recently been reported as 6.1 percent from a 26-year high of 10 percent in 2009, and the Fed’s estimate for full employment, one of its economic-policy goals, has gone from 5.2 percent to 5.5 percent. Since these figures were released, the Commerce Department has increased its estimate of growth in GDP from a rate of 4.2 percent annually to 4.6 percent. This is the best performance from the biggest economy in the world since the final quarter of 2011.
Additionally, compared to previous estimates, there have been upward revisions driven by strengthening business spending and export growth. Compared to the 2.1-percent annual contraction in GDP that was reported in the first quarter of 2014, this is quite a turnaround in sentiment. That poor performance was attributed to extreme weather conditions and therefore has not contributed significantly to long-term forecasts. The upward revision from the Commerce Department was not a surprise to Wall Street. The gains of the second quarter through 2014 have been driven by much more than just a weather-related turnaround, and market participants are highlighting that there are factors, such as commercial activity, underpinning a sustainable phase of economic expansion, with strong growth throughout the third quarter. It is this type of activity that is leading to forecasts that the US Fed may possibly raise interest rates sooner than intended—i.e., before mid-2015.
Although the possibility of a rate hike has increased, the majority of market participants still believe that rates are most likely to stay on hold until mid-2015. Most parties believe that the Fed will capture any above-expected economic gains and growth and direct that towards supporting the labour market rather than affecting the markets through premature rate rises, all the while keeping a close eye on inflation. All involved parties will be scouring the upcoming employment report for further clues—particularly those related to the rate of wage growth—as the Fed has indicated employment and wage concerns are high on their agenda. However, much uncertainty remains in the markets and understandably follows through as a “knock-on” effect in the dynamics of market behaviour. Based on the vaguely indicated timeframe for raising rates six months after bond purchases end, the likely timing of rises will be April 2015 or June 2015, considerably sooner than the December 2015 estimate put forward by the FOMC previously. Given these factors, it is most likely that rates will rise very gradually, not with a spike, so as to retain stability and sustainability in the economy and financial markets.
The Fed has stated that the benchmark interest rate will remain low for a “considerable time” after the central bank ends the bond-purchase programme that was put in place to stimulate growth. Fed officials began to rely on forward guidance to retain yields at low levels in short-term debt maturities after cutting the federal funds rate to almost zero. Bond purchases, which have pushed down long-term yields, have acted as a complementary easing tool. Given the expected rise in interest rates, the short-to-intermediate portions of the yield curve in the fixed-income market are expected to increase—and there is likely to be increased volatility for these maturities of fixed-income assets. Volatility in this area of the market has already seen increases as speculation regarding the FOMC’s and Fed’s plans for interest rates remains far-ranging. Given interest-rate rises, it is likely that the US dollar will gain in strength—especially as bond-purchase programmes are still a vital part of supporting the domestic economies of other nations across the globe. In particular Japan has been ramping up bond purchases, and the European Central Bank has been rolling out a plan of asset purchases, making the US currency relatively stronger. The US currency strengthening could potentially also have a negative effect on US corporate earnings—based on foreign trade, and import-export balances stemming from changes to existing currency-exchange rates. This is another delicate factor in the balancing act of raising rates—each nation’s economy seeks to keep earnings appreciating and feeding the economy and its growth; therefore economic policy must be handled carefully to avoid stifling business in this area.
Minutes from the last Fed meeting have shown that the majority of Fed policymakers believe the US economy is now strong enough for interest-rate rises. However, opinion across a broader platform is more mixed. For example, conservative economists are arguing that the Fed should keep interest rates low for a while longer in order to build a more stable economic platform. The four-percent rate of growth recorded in the US economy during the second quarter of this year may be short-lived. Concerns remain that were the Fed to raise rates, the gains would be chased lower, especially given the poor economic performance earlier this year—with growth in the US at 0.95 percent during the first quarter of 2014, well below the three-percent level forecast by the Fed. Perhaps following a concurrent series of reported positive growth figures would be a better time to move rates—suggesting that mid-2015 may be ideal, if strong performance continues until then.
A suitably long period of observing the markets and economy after the artificial support of bond purchasing is removed is required before it can be fully ascertained if the economy is ready for rate hikes. Without this artificial stimulus and involvement in the markets, stock prices may see significant falls and will need to find real stability in the marketplace before having to contend with higher costs of borrowing. Only after the bond-purchasing programme is phased out will the true dependency of the markets on the quantitative-easing programme be properly identified. There is a risk that low interest rates and Fed support has created a bubble in financial markets. This poses a downside risk to Wall Street and may lead to a spike in volatility, which has the potential to negatively impact client portfolios and investments.
Federal Reserve Chair Janet Yellen has commented through the press that she wants investors to be prepared for the possibility that the Fed will raise interest rates sooner than they currently project. Despite these warnings, volatility across stocks, bonds and currencies worldwide is currently close to record-low levels. Economic advisers are suggesting that this absence of wide swings in asset prices reflects investor complacency about the central bank’s intentions. This creates a danger in the marketplace as economic strength may speed up the timetable for Fed rate rises, and this may prompt a sudden surge in volatility that complacent market participants are not expecting. This could impact the markets negatively, undo the progress made and jeopardize economic expansion.
Minutes from the July 2014 Fed meeting and the Bank for International Settlements’ annual report released in June 2014 are now suggesting that low interest rates have failed to address certain economic problems in the US and are instead providing a short-term solution that glosses over the core issues. A particular concern is that consumer spending has not been stimulated in the real economy; savings rates are still high, depriving the economy of what it needs to get moving properly and generate satisfactory growth. Rises in wages are too slow, and incomes are depressed to levels that are insufficiently low. This has stifled consumer spending. In addition the housing-market recovery has performed below expectations; despite mortgage rates remaining low and housing appearing to be relatively affordable, various factors have restrained demand, including low incomes and high levels of debt. Additionally difficulty in obtaining mortgage credit, particularly by first-time homebuyers, remains high.
The Fed’s six-year period of monetary policy may not have delivered the economic stimulus it intended. However, even conservative economists consider a continuation of low rates as a sensible choice, particularly in controlling inflation and stimulating it to above a two-percent level.
Participants at the July Fed meeting commented that inflation had moved somewhat closer to the committee’s two-percent long-range objective and generally saw the risk of inflation running persistently below their objective as having diminished somewhat.
Given the official FOMC comments, Fed Chair statements, market speculation, economic vulnerability and a number of other important factors, it is most likely that rates will rise gradually from mid-2015. However, sustainability will underscore decision-making at all times. Only after a proper period of market observation following the end of bond-purchasing will the true stability of the US economy and financial markets be properly assessed. The markets may be more vulnerable than expected, and investors and market participants should prepare for volatility and uncertainty for an extended period.