We do not fear the Fed
Disappointed. That was our initial reaction to learning on September 17th that the Federal Reserve would again leave unchanged its accommodative monetary policies which date from the 2008 financial crisis. Even a small rate hike (say 12.5 basis points or 1/8%) would have been a positive signal that the Fed is confident in stronger domestic economic growth and sees less need for the unprecedented support of asset prices. While we expect short term market volatility surrounding the onset of tightening (interest rate hikes), we do not fear the Fed. When tightening does occur, that should be an affirmation that the US economy has recovered to the point where it is strong enough to withstand the shocks of external forces (a renewed slide in crude prices, a strengthening dollar, a slow growing China and a weakening Brazil are examples).
While we must acknowledge that even a gradual pace of tightening could upset the markets, we think that this next cycle of interest rate hikes will be different. A recent Market View article of Lord Abbett Funds said it best, “Historically, the Fed has raised rates to temper excessive economic growth or lower inflation. The Fed’s current objective is instead to normalize interest rates without adversely affecting economic growth. Arguably, this more economy-friendly objective could favor equities and other economically sensitive securities more than past rate hikes, when slowing the economy was a primary objective.” Whenever the next cycle begins, it should be quite different than the last tightening cycle, which ended in 2006, when the federal funds rate went from 1% to 5.25% in just two years. At the June FOMC meeting, Fed Chair Janet Yellen emphasized that even after the initial rate hike that Fed monetary policy will remain accommodative for some time even as the process of rate normalization begins and that the longer term pace of rate increases will be gradual. Most analysts see a 50/50 likelihood of the initial hike coming at either the Oct 27-28 or Dec 15-16 FOMC meeting. When it comes to predicting how the next rate hike cycle will play out, we will continue to focus less on the timing of rate lift off and more on the magnitude and speed of the change.
In her September briefing, Fed Chair Yellen offered this comment as the reason for the no-action on interest rates. “In light of the heightened uncertainties abroad and the slightly softer expected path for inflation, the committee judged it appropriate to wait for more evidence, including some further improvement in the labor market, to bolster its confidence that inflation will rise to 2% in the medium term.” Putting aside our disappointment for a moment, we must admit that all makes sense. Since the earliest days post-crisis, the Fed has maintained a dual mandate of encouraging job creation (reducing unemployment to about 5%) and controlling inflation with a long held target of 2%. Plunging worldwide commodity and energy prices have made the inflation target a difficult one to meet as shown in the most recent CPI data which showed annual inflation running at a low +0.2%.
Communication, both timely and transparent, by the Fed will be an important ingredient for success as it guides the markets through the initial rate hike and long march to interest rate normalization. Clarity of purpose and intention will go a long way to reducing investor uncertainty and the accompanying market volatility. We must note, with a chuckle, that clarity has in the past been missing from some Fed communication as shown in these words of former Fed Chair Alan Greenspan: “I know you think you understand what you thought I said, but I’m not sure you realize that what you heard is not what I meant.”