A Momentous Fed Rate Hike as Afterthought

Article source: CMDGroup

The Federal Reserve has been waffling about raising interest rates for so long, it seems like an afterthought now that the step has finally been taken.

On December 16, the FOMC (Federal Open Market Committee) moved up the federal funds rate from a range of 0.00%-0.25% to 0.25%-0.50%.

It’s a disservice not to acknowledge the momentous nature of this event.

Nearly a decade has passed since the last rate hike. Over the past seven years, the yield has been flat and barely above zero.

The current shift upward has little to do with the fed’s twin mandates of job creation and achieving an inflation target of 2.0%.

While the jobless rate has tightened to 5.0% and month-to-month employment is now averaging +200,000 jobs, many individuals are still complaining they’re working part-time when they’d rather be full-time and hourly and weekly earnings remain stuck at between +2.0% and +2.5% annually.

On account of the big drop in the world price of oil, the overall cost of living is little different from last year, although the ‘core’ inflation rate – which omits volatile energy and food components – is ahead 2.0%.

A rapid ramping up of prices, though − especially with global demand for most commodities still languishing – isn’t appearing on most radar screens.

Furthermore, the higher level for the federal funds rate will provide more lift for the value of the U.S. dollar, inhibiting exports and encouraging imports. The former become more expensive in foreign markets while the latter fall in price at home.

Instead, the latest move is mainly about ‘normalization’. The fed wants to re-acquire a more complete arsenal of weaponry with which to influence the economy.

Traditionally, there is a level for the federal funds rate that is neutral. It neither provides stimulus nor takes it away.

Before the Great Recession, that figure was most often close to 3.5%.

It gave the fed a wonderful staging area from which to direct affairs.

If restrain was needed, yields could be higher; but if more juice was warranted, they could be shifted lower.

The interest rate regime of the last seven years removed the second of those two options. For example, it’s hard, though not impossible, to have an interest rate less than 0.00%.

With fiscal policy (i.e., government expenditures in excess of revenues) staying mainly on the sidelines, the new neutral level for the federal funds rate is probably only about 2.0%, with 2.5% as an outside limit.

Most analysts and economists seem to be expecting this new goal to be achieved through four 25-basis-point (i.e., where 100 basis points equals 1.00%) increments in each of the next two years.

But there is a wild card in this high-stakes poker game.

During several phases of quantitative easing, the fed acquired a vast amount of U.S. Treasury debt, which is now skewing its balance sheet.

As attempts begin to divest those assets, the supply being sent out into the financial marketplace may well exceed possibly-hesitant demand, necessitating some price discounting. It’s in the nature of secondary bond transactions that a drop in price means an increase in interest rates.

Also, the appearance of a flood of public notes may crowd out corporate paper. The only option for firms seeking to borrow money through bond issuances will be to raise their interest-rate offerings.

The bottom line is that small, barely-discernible and seemingly reasonable, at least in the short-term, increases in the official central bank interest rate may be an ideal that proves harder to achieve than presently anticipated.

It’s more likely to require a balancing act worthy of a performer with Cirque du Soleil.

In any event, the Federal Reserve is clearly embarking on a more active agenda in 2016 than in 2015.

That leads to a final point. The actions the fed is starting to take will almost certainly raise its profile as a talking point during the debates leading up to the next Presidential election scheduled for November, eleven months from now.

Tags: Alex Carrick, CMD, CMDGroup

Category: CMD Group

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