Will the Fed Raise Interest Rates When the US economy is so Weak?

It was a split decision between markets and central bankers in US trade on Friday, if we use the price of gold as a gauge.

Janet Yellen delivered her much-anticipated (and boring) speech, during which the gold price increased by around US$15 an ounce. This was surprising given the speech was apparently ‘hawkish’. Yellen said the case for a rate rise had strengthened in recent months.

Yet the last part of her speech, under the heading ‘where do we go from here’, discussed the Fed’s options for dealing with recessions when interest rates are already so low.

It took some follow-up comments from Fed Vice-Chair Stanley Fischer to support the rate rise argument, and the gold price subsequently fell back to where it started the day.

The implication is clear: One of the Fed’s main policy tools now is ‘jaw-boning’, or forward guidance. But markets are so sensitive to rate movements the Fed feels the need to talk extensively about its ability to ease and fight recessions while preparing markets for an imminent rate hike.

It doesn’t sound too convincing. But it’s a very deliberate strategy that has no doubt been discussed and refined for hours on end in the depths of the Marriner S Eccles building in Washington — the home of the Federal Reserve.

It gives the Fed an ‘out’, depending on the strength of the incoming data. Which is convenient, because the incoming data is anything but definitive in regards to the health of the US economy.

The employment numbers have been decent recently, without being unambiguously strong. But economic growth remains well below any definition of strength or health.

The US Commerce Department revised down second-quarter economic growth from 1.2% to 1.1%. That was largely due to a run down in inventories; business investment was weak, too. On the positive side, consumer spending rose strongly in the second quarter.

That caps a weak first half of the year for the US economy. But the Fed clearly thinks the weak patch is over. As Yellen said on Friday:

In light of the continued solid performance of the labour market and our outlook for economic activity and inflation, I believe the case for an increase in the federal funds rate has strengthened in recent months.

Further along in her speech, Yellen followed that up with a discussion about the Fed’s ability to manage a recession based on simulations of various scenarios:

Finally, the simulation analysis certainly overstates the FOMC’s current ability to respond to a recession, given that there is little scope to cut the federal funds rate at the moment. But that does not mean that the Federal Reserve would be unable to provide appreciable accommodation should the ongoing expansion falter in the near term. In addition to taking the federal funds rate back down to nearly zero, the FOMC could resume asset purchases and announce its intention to keep the federal funds rate at this level until conditions had improved markedly — although with long-term interest rates already quite low, the net stimulus that would result might be somewhat reduced.

No wonder the market rallied following the speech!

And that forced Vice President Fischer to hit the airwaves, saying that a rate hike in September is a possibility, followed by another in December.

If you were in any doubt about the Fed’s ‘forward guidance’ strategy, the Cleveland Fed President, Loretta Mester, told the Financial Times in an interview over the weekend that the case for a rate rise was ‘compelling’.

And there you have it.

The Fed wants the market to believe that rates are heading higher, while reassuring them that a recession will be dealt with. Because everyone knows that higher rates mean weaker asset prices, you can expect to see stock markets treading water or going lower…for this week at least.

It also means that this Friday’s US employment data will be particularly crucial for markets. A strong number means markets will price in a rate hike as soon as the 21 September Fed meeting. A weak number will mean a rate hike goes back out to sometime in 2017.

And then there’s the minor matter of a US election in November. Does the ‘independent’ Fed raise rates a month-and-a-half out from a presidential election?

Or will Janet Yellen keep the Fed out of it until after November?

As you can see, there is a fair bit of uncertainty ahead for investors to deal with in the immediate term. While there is always uncertainty, the Fed, by trying to hedge its bets, is actually feeding this with their jaw-boning and forward guidance strategy.

Let’s put things into perspective. The US economy expanded at an annual rate of less than 1% in the first half of 2016, following a December 2015 rate hike. Despite this weak growth, employment data has been relatively good, and this is why the Fed remains open to another rate hike.

But let’s be frank, what central bank is really going to raise interest rates while the economy is so weak? Sure, growth should improve in the third quarter as inventories rebuild, but you’re hardly looking at a broad-based recovery.

While this might be the case, the important thing is that the Fed’s strategy is working. The media are on board. The Fed has got markets thinking that a rate hike is a real possibility in September and/or December. And if everyone thinks it, you’ve got to think it too, at least in the short term.

But in reality, not everyone buys the Fed’s rhetoric. There will be plenty of people waiting for the right moment to bet against the Fed. This will make for a very interesting September — traditionally the most volatile time of the year.

Cheers,

Greg Canavan,
For Markets and Money


Greg Canavan is a Contributing Editor at Markets & Money and Head of Research at Port Phillip Publishing. He advocates a counter-intuitive investment philosophy based on the old adage that ‘ignorance is bliss’. Greg says that investing in the ‘Information Age’ means you now have all the information you need. But is it really useful? Much of it is noise, and serves to confuse rather than inform investors. And, through the process of confirmation bias, you tend to sift the information that you agree with. As a result, you reinforce your biases. This gives you the impression that you know what is going on. But really, you don’t know. No one does. The world is far too complex to understand. When you accept this, your newfound ignorance becomes a formidable investment weapon. That’s because you’re not a slave to your emotions and biases. Greg puts this philosophy into action as the Editor of Crisis & Opportunity. He sees opportunities in crises. To find the opportunities, he uses a process called the ‘Fusion Method’, which combines charting analysis with more conventional valuation analysis. Charting is important because it contains no opinions or emotions. Combine that with traditional stock analysis, and you have a robust stock selection strategy. With Greg’s help, you can implement a long-term wealth-building strategy into your financial planning, be better prepared for the financial challenges ahead, and stop making the same mistakes that most private investors do every time they buy a stock. To find out more about Greg’s investing style and his financial worldview, take out a free subscription to Markets & Money here. And to discover more about Greg’s ‘ignorance is bliss’ investment strategy and the Fusion Method of investing, take out a 30-day trial to his value investing service Crisis & Opportunity here. Official websites and financial e-letters Greg writes for:

 


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