Fed Set To Pull Trigger Tomorrow – A Good Thing Or Bad? by Gary D. Halbert
FORECASTS & TRENDS E-LETTER
by Gary D. Halbert
December 15, 2015
IN THIS ISSUE:
- A Primer on the Fed Open Market Committee
- The Case FOR a Fed Funds Rate Hike Tomorrow
- The Case AGAINST a Fed Funds Rate Hike Tomorrow
- The Fed’s Dilemma – Crying Wolf Too Often
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The Fed Open Market Committee (FOMC) which sets US monetary policy convened in Washington this morning for its last meeting of 2015. It is widely expected that the Committee will vote to hike the key Fed Funds rate for the first time in almost a decade before the meeting concludes tomorrow.
The FOMC slashed the Fed Funds rate from 5.25% in late 2007 to near zero by late 2008 during the financial crisis and recession. It has kept the key lending rate at 0.00% to 0.25% ever since in an effort to stimulate the economy, in addition to buying an unprecedented $3.7 trillion in Treasuries and mortgage-backed securities in a process known as “quantitative easing” or QE.
It is not entirely certain that the FOMC will hike the Fed Funds rate tomorrow, but that is the prevailing consensus. Based on the minutes from the last FOMC meeting in late October, which were released on November 18, it is clear that Fed Chair Janet Yellen has a majority of FOMC voting members ready to support a rate hike if she chooses to do so.
It is also not entirely clear how much the Committee might raise the Fed Funds rate should it decide to enact “lift-off” tomorrow. The prevailing consensus is that the first rate hike would be only 25 basis points (0.25%), but the Fed has provided very limited guidance as to the size of the expected increase. Assuming the rate hike is only 25 bips, the other question is from where – the Fed Funds rate is currently just under 0.15%.
There are strong arguments on both sides of the lift-off issue. Many believe the Fed has already waited way too long to start normalizing interest rates and are adamant that lift-off should begin tomorrow. Many others, however, believe that the economic recovery is still too weak and the Fed should delay lift-off until sometime next year at the earliest.
It is these two arguments that we will discuss today, ahead of tomorrow’s key decision. But before we get to that discussion, let’s do a quick review of the makeup of the Fed Open Market Committee, the most powerful monetary policy body in the world.
A Primer on the Fed Open Market Committee
The Federal Open Market Committee is charged by law with overseeing the nation’s open market operations (ie – the Fed’s buying and selling of United States Treasury instruments and in some cases other securities). It is this Federal Reserve Committee which makes key decisions about interest rates and the growth of the United States money supply.
The FOMC is the principal organ of United States national monetary policy. The Committee sets monetary policy by specifying the short-term objective for the Fed’s open market operations, which is usually a target level for the Fed Funds rate (the rate that commercial banks charge between themselves for overnight loans).
The FOMC also directs operations undertaken by the Federal Reserve System in foreign exchange markets. Any Fed intervention in foreign exchange markets is coordinated with the US Treasury, which has responsibility for formulating policies regarding the exchange value of the US dollar.
The FOMC meets eight times per year (about every six weeks) to set key interest rates, such as the Fed Funds rate and the Discount rate and to decide whether to increase or decrease the money supply, which the Fed generally does by buying and selling government securities.
Today’s FOMC consists of 12 members: the seven members of the Federal Reserve Board and five of the 12 regional Federal Reserve Bank presidents, but only 10 of the 12 members actually vote. The other two serve as alternates if needed.
Five of the Federal Reserve Bank presidents serve one-year terms on the FOMC on a rotating basis. The rotating seats are filled with Fed bank presidents from Boston, Philadelphia, Richmond, Cleveland, Chicago, Atlanta, St. Louis, Dallas, Minneapolis, Kansas City and San Francisco. The New York Fed president always has a voting membership.
The current voting membership of the FOMC includes:
Janet L. Yellen, Board of Governors, Chair
William C. Dudley, New York, Vice Chairman
Lael Brainard, Board of Governors
Charles L. Evans, Chicago
Stanley Fischer, Board of Governors
Jeffrey M. Lacker, Richmond
Dennis P. Lockhart, Atlanta
Jerome H. Powell, Board of Governors
Daniel K. Tarullo, Board of Governors
John C. Williams, San Francisco
The Case FOR a Funds Rate Hike Tomorrow
There are numerous reasons why the Federal Reserve should raise short-term rates at its policy meeting today and tomorrow. While I won’t bore you with all of them, here is a summary of perhaps the most common prevailing wisdom in favor of a rate hike now.
The Fed has held short-term interest rates near zero for seven years now. Normalization of short-term rates has to occur at some point, and the economy seems more than strong enough to handle slightly higher rates.
The November jobs report on December 4, like the October report before it, affirmed the strength of the recovery as once again the US added more than 200,000 jobs to more than absorb new entries into the workforce and help push the nation’s unemployment rate even lower.
Also last week, Chair Janet Yellen said she was “looking forward” to when the Fed “begins to normalize the stance of policy” and that “doing so will be a testament … to how far our economy has come.”
This is classic Fed-speak suggesting that because the economy is strong enough, the Fed needs to begin raising interest rates to head off a new round of price inflation. Yet inflation is nowhere in sight. According to the Bureau of Labor Statistics, consumer inflation is running at an anemic rate of only 0.2% so far this year – not a problem by any stretch.
The truth is that the Fed is desperate to raise rates so that it has some room to cut interest rates to fight the next recession, which it worries may be just over the horizon.
In any event, the Fed wants us to believe that the table is set for the first increase in US interest rates in more than nine years, and should be heralded as a huge vote of confidence in the economy – something that, like Janet Yellen, all investors should look forward to.
Are you buying that? No, I didn’t think so. Me either.
The Case AGAINST a Funds Rate Hike Tomorrow
As we have approached tomorrow’s likely increase in the Fed Funds rate for the first time in over nine years, several groups that rarely agree on anything have coalesced to oppose lift-off at this time. These groups include former Treasury Secretary Lawrence Summers, market monetarists, gold bugs and even some so-called “hard money” activists (ie – conservatives).
Several factors contributed to this meeting of unlikely minds, but one was an article on RealClearMarkets.com last week by Louis Woodhill, a Forbes contributor. Woodhill believes the Fed should target “the real value of the dollar,” but given the bank’s preferred policy tool of a short-term interest rate hike, “raising it right now is obviously the wrong thing to do,” he wrote.
As evidence, Woodhill cited the recent decline in long-term Treasury yields, inflation expectations and commodity prices, including gold, even as the Fed’s monetary base has stabilized – and inflation is nowhere in sight. Woodhill sounds like a more polite version of The New York Times’ liberal columnist Paul Krugman when he challenges conservatives to “open their eyes and stop predicting the imminent arrival of rampant inflation.”
Harvard economics professor and former Treasury Secretary Larry Summers, a liberal Keynesian by trade, weighed in again last week with cautionary words for the Fed. Summers adamantly believes that the US economy is nowhere near strong enough to withstand the series of rate hikes the Fed has in mind.
While I rarely agree with Mr. Summers on most issues, he may be correct on this one.
While not all his warnings warrant repeating, the essence of Summers’ argument is that the Fed Funds rate has been falling over almost a decade. If all the Fed has to show for seven years of near-zero interest rates and a $4.5 trillion balance sheet is real GDP growth averaging only 2.1% since the end of the recession in June 2009, then the Fed Funds rate should not be raised at this time.
Summers also points out that the financial markets are transmitting additional warning signs. High-yield bond spreads have widened as troubled loans and default rates mount. Emerging market economies are taking a hit on their dollar-denominated debt. The trade-weighted dollar index is near a 12½-year high, and the inflation-adjusted dollar index is at a 10-year high. Industrial commodity prices, which are sensitive to changes in global demand, are plunging.
So why is the Fed so determined to tighten? As I argued above, policy makers would like to put some distance between the funds rate and zero, because they want some additional ammunition (rate cuts) before the next recession rolls in.
The other question is why the Fed is insistent on raising rates now?. The world’s major economies are diverging, with Europe, Japan and China requiring additional stimulus from their central banks. The dollar is likely to strengthen further, crimping US exports and restraining import prices – especially if the Fed hikes interest rates. Likewise, the renewed decline in oil prices is going to prevent inflation from moving up to the Fed’s 2% target, a supposed premise for any Fed action.
For all of these reasons and more, a growing cadre of diverse groups believes the Fed should not hike the Fed Funds rate tomorrow. The case seems abundantly clear that inflation is simply not a threat anytime soon, especially with oil prices in freefall once again.
Dilemma – Crying Wolf Too Often
The Fed, via Ben Bernanke, began warning about the end of QE and raising the Fed Funds rate all the way back in late 2013. Bernanke backed off, of course, when the stock market tanked temporarily back then.
Yet when Janet Yellen took over as Fed Chair in January 2014, talk of lift-off resumed and has continued since then. She has talked of the need for normalization of interest rates ever since in various speeches and before Congress.
The point is that the Fed may now feel that if it doesn’t enact at least a token Fed Funds rate increase tomorrow, it may risk losing even more credibility than it already has. That is not a good position to be in, yet it may well be the case.
So the question is, what might a rate hike look like tomorrow? The Fed Funds rate has been hovering just below 0.15% over the last week or so. Fed-watchers like me are wondering what a 25 basis-point rise in the Fed Funds rate would look like.
The FOMC’s current target range for the Fed Funds rate is 0.00% to 0.25%. Recently the Fed Funds rate has been trading near 0.15%. So does that mean a quarter-point hike would be from 0.25% to 0.50%? Or does it mean a rise from 0.15% today to 0.40%?
We just don’t know, but we will probably find out tomorrow. The Fed Funds futures market predicts an 81.4% probability that the Fed will hike tomorrow.
At the end of the day, a 25 basis point increase in the Fed Funds rate at this point probably doesn’t mean that much. Maybe the Fed simply feels compelled to do something – the “one and done” theory. The key will be the Fed’s language in tomorrow’s policy statement as to its intentions going forward.
I will have more analysis in my blog on Thursday. If you haven’t subscribed to my blog, you are missing some good info each week. To subscribe to my free weekly blog, CLICK HERE.
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Very best regards,
Gary D. Halbert