How much longer can the Fed hold out?
The wait is almost over.
On Wednesday afternoon, we’ll know whether Federal Reserve has decided to raise interest rates again for the first time since last December. Stocks would likely react negatively to such a move because the futures market assigns only an 18 percent chance of such a move, given recent weakening in the economic data and the Fed’s history of erring on the side of more stimulus rather than less.
And while compelling arguments are being made to justify raising rates to 0.75 percent (from 0.5 percent now) -- given an unemployment rate of just 4.9 percent, among other reasons -- many more calling for patience until December or possibly into 2017. Those arguments point to a recent weakening of the economic data.
The trouble, as highlighted by Bank of America Merrill Lynch economist Michelle Meyer, is that the Fed must be careful to sound steadfastly optimistic in the economy’s future while acknowledging that growth isn’t yet strong enough for another increase in borrowing rates. That’s a tough balancing act.
And a slip-up could send stocks, which have been trading near the 18,000 level on the Dow Jones industrials index since 2014, careening lower.
As a reminder, the stock market’s impressive post-Brexit rally out of the late June low was stalled in July after the Fed’s surprisingly confident policy statement that month proclaiming “near-term risks to the economic outlook have diminished.” The run-up was further weakened by a late August speech by Fed Chair Janet Yellen, in which she said she believed the case for a rate increase had “strengthened” in recent months.
The Fed’s last “dot plot” of individual members’ interest rate projections, from June, had penciled in two quarter-point hikes before year-end. Ostensibly, at the September and December meetings.
But in recent weeks, a weak August jobs report and ongoing evidence of a U.S. manufacturing slowdown has dimmed expectations for a September hike. Corporate earnings are in an outright recession that’s expected to stretch into a sixth quarter. And uncertainty is high heading into the U.S. presidential election in November.
The Bank of Japan has also complicated the situation, roiling long-term government bond prices in recent weeks teasing an effort (which it finally announced on Wednesday) to limit the declines in long-term interest rates to take the pressure off bank earnings -- and savers.
With interest rates so low, bond prices are extremely sensitive to any suggestion or action that lifts rates. An unexpected hike from the Fed today would likely be destabilizing, with panicked selling giving way to higher volatility. That would also force selling as banks and other institutional bond investors trim positions to reduce risk exposures. Better to wait for calmer conditions.
Yet too much of a good thing would be bad, too. I’m talking about an overly dovish statement that talks up downside risks to the economy or even discusses an “inflation overshoot” as the Bank of Japan just committed to. That would come in the form of a Fed promise to let inflation rise above its 2 percent target to ensure the threat of deflation and a new downturn has passed.
Perversely, such a strategy could weaken bond prices by causing inflation expectations to surge.
While the U.S. economy is far from being truly healthy, it’s not exactly handicapped, either. And continuing an ultra-easy monetary policy for much longer creates its own problems, such as the risks of asset bubbles and shoddy lending practices.
Ed Yardeni of Yardeni Research, one of the voices calling for the Fed to hike today, noted that real median household income jumped 5.2 percent in 2015 -- the best one-year gain since the data series started in 1968. He also points to fast-rising inflation in areas like rent (up 3.8 percent year-over-year in August) and health care (up 4.9 percent, the most since 2008) that could dampen consumer sentiment and push up overall inflation rates (core inflation is at 1.6 percent and rising).
So mark your calendars: If not today, a rate hike is coming in December.
