What is the Fed’s Next Move?

The Future of Interest Rates

It’s hard to meet a banker today who doesn’t want to banter about the Federal Reserve’s next monetary step.  Despite the talk of an imminent Fed hike for the last two years, it now seems right around the corner – or does it? We believe that bank planning and strategy should be probabilistic – decisions should be made based on many possible outcomes with each outcome having an assigned probability of occurring.  Decisions should not be made on whether the CEO believes that the Fed will raise rates in September, December or March.

However, speculating about the Fed is like that old banking joke: A bartender notices that whenever the banker comes into the bar he orders three of the same drinks and sips them one after the other.  He asks the banker why that is?  “Simple,” says the banker.  “My former CFO and CCO and I would routinely have a drink after work together.  We vowed that as long as we stay in banking we would have at least one round together every week.  However, they both moved to a bank in Minnesota, but as long as we three stay in banking I will always remember them by buying a drink for all three of us and drinking on their behalf.”  Made sense thought the bartender.  A week later the banker comes in and orders only two drinks and sips one and then the other.  “Sorry to see that one of your friends lost his job in banking, but that is common in today’s banking environment,” said the bartender.  “Oh no,” said the banker, “they still have their banking jobs and I have mine, it’s just that I quit drinking.” 

In similar fashion, while most banks have sworn off Fed speculation some time ago, it doesn’t stop anyone from talking about it. Given that speculation will occur, we thought we should recap the top three reasons why the Fed should, or should not, raise interest rates.

Three Good Reasons for the Fed Not to Increase Rates

Inflation is low, even excluding the volatile food and energy prices, and is well below the Fed’s target of 2 percent. If inflation has been consistently below the Fed’s target for more than a year, why would the Fed be considering raising rates now?

China’s economy, the second largest in the world, is teetering.  While that economy is still expanding at 7% per year, dubious as that measure might be, it is now showing signs of a possible hard landing.  All indicators look negative, and no one has seen a centrally planned economy navigate turbulence in the long run.  A severe slowdown in China means declining Chinese imports which cuts US corporate growth, and ultimately a drag on the US economy.

By many standards, the labor markets have healed but have not fully recovered from the recession. Much of the problem centers on discouraged workers not returning to the job market and the ratio of employment to working-age population remains depressed.

Three Good Reasons for the Fed to Raise Rates

The Fed is currently at a stimulus void if another recession hits.  With a ballooned balance sheet that is already distorting market forces and short-term rates at zero, there are few monetary options left to stimulate the economy if additional stimulus becomes warranted.  While the Fed has adeptly navigated the economy out of the depths of a crisis, the Fed has not repealed the business cycle and the next downturn is one-day closer every new day.  In order to recharge the monetary stimulus battery, short-term rates must first be raised.

Most members of the Fed have publicly acknowledged or tacitly indicated that they are uncomfortable at the absolute level of overnight cost of capital in context of the current state of the economy.  Zero interest rate was appropriate as an extraordinary accommodation in a collapsing economy, however, it is probably not the right interest rate policy with GDP around 2.5 to 3.0% and unemployment at 5.3%, and various asset bubbles starting to form.

The Fed has widely broadcasted that rate increases will be a gentle campaign.  Rather than hike 25bps every meeting, the communication has clearly skewed the market to a slow rate rise.  Therefore, to get to a “normal” rate, whatever that final point might be, an earlier start is crucial to maintain a gradual rise in interest rates.  This is especially important as Janet Yellen indicated that she believes that the labor market will strengthen further and her stated belief that the economy faces more than cyclical headwinds (and those secular changes or structural issues, she cannot control through monetary policy).

Finally, another issue that often comes up in these conversations is the comparison of the U.S. to Japan.  If the US economy is expected to behave like the Japanese did in 2000, then raising rates at this juncture risks an economic crash (a strikingly similar situation occurred in Japan).  Despite some similarities, the discussion can be interesting but not very enlightening. Japan has some structural issues with demographics, with policy and with its workforce that makes it unlike the US.  

Hopefully, these arguments give you decent fodder for your next conversation about the Fed and rates. More importantly, hopefully this recap helps you decide if now is the time you think the Fed will raise rates. Until then, bankers must look past the next few months to properly handle their asset/liability management and be ready for anything that comes their way.