Will They or Won’t They

Welcome to reality TV, Federal Reserve style.  As the Federal Reserve grapples with the decision of whether or not to raise short-term interest rates for the first time in almost ten years, the lead-up is playing out like a made for TV drama.  It’s the newest in reality TV.  Now, don’t get me wrong, this won’t set any viewing records, but for geeks like us, this decision will be as anticipated as the OJ verdict.

Well, maybe not that much.

The decision to raise or not is really not the issue, because we know they will have to begin raising rates one of these days.  The issue is the immediate and near-term reaction by the markets and the threats to world economies.  How will it be interpreted?  What will the reaction be in the days and months following to the global bond and stock markets?  There is a lot at stake.  Will they signal that they are “one and done”? Or will they indicate a steady, yet slow pace of gradual rate hikes?

How did we get here?  After the financial crisis, that began in 2007 and stressed the global markets to the point of breaking, the Federal Reserve took unprecedented steps to “right the ship” that was the U.S. economy and entire financial system.  Never before used measures by the Fed were implemented to stabilize the credit system and markets.  This included slashing the Federal funds rate, the rate that banks charge each other on overnight loans, also known as short-term interest rates, to zero.  But that wasn’t enough.  They then embarked on what became a series of bond buying programs, referred to as quantitative easing “QE” to further shore up the financial system and stimulate the economy.  This proved (intentional or not) to be a big boost to stocks prices.  With rates at near zero and yields at decade lows, money was “forced” into stocks.

With each passing year and Federal Open Market Committee (FOMC) meeting since 2007, there has been little speculation about what the Fed would do.  They had to make sure that the U.S. economy was on solid footing before any thought of increasing rates to a more normal level.   It was deemed time and time again that the economy was just too fragile to begin increasing rates.

But that hasn’t stopped many of the so-called experts and prognosticators from trying to predict when rates would start to rise.  I remember sitting across from an “expert” Chief Economist back in 2010 predicting that we were only two or three quarters away from rate increases.   That was five years ago, and we are still waiting.  This has been one of the most discussed and debated topics over the last few years and almost everyone has gotten it wrong.  Really makes you wonder why these people even try to predict future events.  It’s a fool’s errand.  Very credible economists and market folks have butchered this call,

further convincing me that predictions, even by very credible people in the investment world, should largely be ignored.  (But that’s an editorial piece for another day.)

The Fed essentially has only two monetary policy mandates:  to achieve maximum employment and stabilize prices /steady inflation.  Since the Great Recession the labor market has improved, at least according to their statistics, (yes, more cynicism) to the point that unemployment has dropped to around 5.3%, a level consistent with their goal.  The problem is inflation or lack thereof.  It’s running very low.  The Fed has a roughly 2% target.  Comments from FOMC members over the last few months have fueled speculation that the Fed may move.  They see improving conditions in the economic data to

suggest that we will see a gradual rise over the near term towards the 2% stated goal.  The problem is, many see the likelihood of a recession as just as much of a reality.  One false (Fed) move could be devastating to a very slow recovery.  That is why the term “data dependent” has become the mantra for policy makers over the last many meetings.

Low inflation isn’t the only headwind, however.  Many other economies around the world, especially in emerging markets (see China), are seeing a substantial slowdown.  Europe has slowed, as has Canada.  Deflationary winds are blowing all around the world.  Commodities like copper and oil have plummeted in value, devastating many emerging market economies.    And, one form of QE or another is being implemented to try to spark growth in many places including Europe.

In fact, the International Monetary Fund (IMF) warned the Federal Reserve back in early July to put off any rate hikes until 2016, stating any increase in rates would cause the dollar to rise further against world currencies, potentially risking U.S. growth and straining emerging markets even more.  If not increased growth, our economy will at least need to sustain this meager level of growth.  Can it, when the rest of the world is slowing?  Many feel that the slightest hiccup will send us right back into a recession.

“Enough already”.  This seems to be the main argument for raising rates.  Those in this camp argue that we are far, far removed from the crisis conditions that triggered the drastic “all but the kitchen sink” approach in the beginning.

Now it’s time for the economy to stand on its own two feet.  We have met the employment (moving) target and the Fed is reasonably confident that inflation will continue to rise.  Hiking rates would instill confidence in the market which would spur further economic activity and growth.  It’s time.  But do enough members of the Fed agree with this line of thinking?  And what if they nudge us off course?  Then what?  With rates near zero, how would the Fed stimulate the economy?  They can’t cut rates.  More QE?  Oh, brother.

The Fed normally tips their hand.  Carefully worded statements usually give hints as to their intentions.  But as we march toward the September 17 meeting, uncertainty is in the air, and the drama grows.  With anticipation building like that of the next Star Wars release (Dec. 14!), coverage of the dilemma dominates the business shows.  And for whatever reason, these Fed governors on the committee, who will be voting whether or not to raise rates, make public comments that move markets, sometimes causing midday spikes or selloffs depending on how they lean.  Other wild predictions of boom or gloom only adds to the market nervousness.

Fortunately at Smith Anglin, we are not in the forecasting business.  We don’t make bets.  We are paid to manage risk.  So we will be tuned in to hear “the decision” and gauge market reaction and the impact to risk levels in the market.  There are compelling arguments on both sides of the debate, but IF I were asked to make a prediction, I would say that the Fed will take a pass.  China and a wild stock market have given them cover.

Too many mixed messages from Fed members have given the market a shaky feel.  The markets hate uncertainty.  That we know.  And even though the stock market action is not where the Fed’s stated interests lie, rest assured they had one eye on a U.S. stock market that plunged 1000 points at the Monday, August 24th open and then whipsawed around the rest of the week.

Stay tuned.