On Wednesday, the Federal Reserve agreed to lift the Federal Funds rate by .25%, bringing the new range to .75 -1.00%. This is the third such hike in the last 15 months. After the announcement— which was well anticipated by markets—stocks, bonds and gold all rallied. How can markets that are supposed to move differently all have the same reaction to yesterday’s hike?
On the face of it, this might seem odd. The prospect of future rate hikes should worry bond investors. The stock market’s reaction is less surprising because stock investor sentiment is high. The Fed’s statement on Wednesday that business fixed investment “had firmed somewhat,” left investors more confident in their optimistic view for future earnings. The gold rally may be a reaction to the Fed’s admission Wednesday that the pace of future increases remains “gradual” and inflation has moved “close” to its target of 2%. Those buying gold as an inflation hedge took this to mean that the Fed sees what they see—higher inflation in the future.
While the Fed would have us believe that these rate hikes are due to rising inflation, it may be that it is using the “inflation is nearing our target” as a cover to normalize short-term interest rates. Inflation reflects the pace at which prices rise over time. A little is good because it reflects healthy demand for goods and services. Too much is a bad thing because it reduces the purchasing power of the consumer’s dollar. None is what central bankers were worried about over the last three years as economic growth waned.
Well, economic growth remains near the same level it has been for the last several years. As a result, core inflation hasn’t really moved much. In fact, if you take away the effect of energy price volatility and housing (using the rent-equivalent measure the Fed uses), inflation has been relatively consistent for two years. If inflation isn’t really the reason for hiking rates, why move now and project two more moves this year?
The Fed needed to exit its zero bound interest policy, used for a number of years in conjunction with “quantitative easing” to stimulate the lackluster economy. Due to the negative effects of a major emerging market slowdown and the aging boomer population, its efforts resulted in keeping the growth rate barely above 1.5% for the last three years. While it is possible that growth would have been lower without these efforts, many acknowledge that the toll the low interest policy was taking on savers and bond investors was not sustainable. As a result, the Fed needed to normalize short-term rates.
The Fed must also acknowledge that we are entering the ninth year of this growth cycle, and there is some likelihood that growth will slow further in the next two years. When this happens, it likes to reduce interest rates, which is hard to do if rates aren’t normalized first.
Economic growth today has improved. However, even by the Fed’s own admission and future forecast, prospects remain muted, as it is projecting about a 2% growth and inflation rate for the next three years.
In addition to using the inflation story as cover for the rate hikes, the Fed has received the promise of something it’s been asking for since 2010—more help in the form of better fiscal policy. As the economy dragged itself out of the malaise of the financial crisis in 2009 and the Fed Funds rate was reduced to 0%, then Fed Chairman Ben Bernanke asked the federal government for assistance to stimulate growth. Time and again in his speeches and testimony on Capitol Hill he would ask for spending and tax relief. Instead, taxes were raised, regulation increased, and the cost of healthcare for businesses grew.
Although the new administration and Congress have been on the job for less than three months, they ran on a platform of doing what the Fed has been asking for—lowering taxes, spending money on infrastructure, reducing regulation, and reducing the cost of healthcare. In other words, getting fiscal policy to assist them in getting the economy back to a higher growth rate. As a result, the Fed has noted that it will monitor fiscal policy changes and consider them as it moves forward.
It is apparent from the healthcare debate that policy change will come slowly. Tax policy change will require some bi-partisanship, and the idea of tackling health care first makes that seem a more remote possibility today. Time will tell. Infrastructure spending and deregulation seem more possible near-term.
Bond investors, skeptics by trade, seem to believe that the Fed’s moderate growth and inflation forecast is realistic. That is why the 10-year Treasury yield declined by .08% after the announcement. They are taking a wait-and-see approach to future fiscal policy improvements. Stock investors, optimistic by nature, are already pricing in future benefits.
Perhaps most importantly, the Fed noted in Wednesday’s press release that “the stance of monetary policy remains accommodative,” reflecting its own view that there is work to be done to lift economic growth in the future. Regardless of the rhetoric, investors and savers alike should welcome higher short-term interest rates.