Ever since former Federal Reserve Chairman Ben Bernanke took extraordinary measures to resuscitate the economy, the capital markets have been awaiting a return to “normalcy.” It’s been a long wait.
As the markets anticipate the September FOMC meeting, everyone is wondering whether Janet Yellen will continue the current Fed Funds interest rate stance or catalyze a long- awaited interest rate increase cycle. Either move would be controversial.
Financial luminaries such as former Treasury Secretary Larry Summers and New York Fed President William Dudley have strongly urged the Fed to hold off on increasing rates, at least for the September meeting if not for the remainder of 2015, fearing that a rate increase may cause an economic contraction. Yet the strengthening US economy, as well as some other global factors, may argue for commencing the long delayed rate increase.
With its historic mandate, the Fed must balance the twin objectives of “full employment” as well as “price stability.” Since the end of the last recession, the Fed has been continually seeking to stimulate economic growth while keeping to its goal of a 2% inflation rate. With inflation well below its target, and only limited signs of pressure on wage growth, the Fed certainly has had plenty of leeway to continue its historic monetary accommodation.
In addition to the tepid economic expansion in the US, the Fed board members are also weighing the impact of other external events in their rate deliberations. The recent devaluation of the Chinese currency, as well as the massive correction in the Chinese stock market, may further support a delay in the increase of the Fed Funds rate. While the US economy may not have to worry about a “contagion” effect from China (equity volatility notwithstanding), a slowing Chinese economy further reduces the demand for global energy. With oil already trading at much lower levels, a significant further reduction in demand will cause even further price softening. This reduces inflationary pressure, giving the Fed additional latitude to forbear a rate increase.
In the current environment, the cards seem to be stacked against a Fed rate increase. An increase would likely harm U.S. exports, due to an appreciation of the dollar against most world currencies. And while any Fed Rate increase would be modest and gradual, the increasing rate cycle would reallocate capital from the US equities markets to the risk-free fixed income markets. Both trends would weaken economic expansion, and increase the odds of a recession.
The Fed isn’t facing a red-hot U.S. economy. Inflation is below target. The U.S. economy is performing better than its counterparts in China and the Eurozone. So why bother with a rate increase at all? The U.S. stock market volatility last week offers a clue. In some cases, a delay (or a “relent” in the current vernacular) of an expected rate increase can trigger an overreaction by the market. Panicked investors would be asking, what does the Fed see that we don’t see? Things must be worse than we thought!
The case for and against a rate increase will be argued right up until the September FOMC meeting. Intervening events, such as a new round of volatility or, conversely, significant gains in employment and wage growth, make this a real cliffhanger. Moreover, the Fed hasn’t forgotten the market gyrations that ensued when the gradual elimination of Quantitative Easing was first discussed (remember the “taper tantrum”?). To avoid a similar market reaction they will be reluctant to back away from their signaled rate increase.
Our view is that the Fed will not increase rates in September, but will characterize the decision as a short delay with an October increase all but certain. This allows the Fed to take the safer route of delaying a rate increase, betting that a bout of inflation is not in the offing, while maintaining its credibility. In times of volatility the markets appreciates the Fed’s discretion.
–John Costa, Managing Director, Auriemma Finance