In late 2015, the consensus estimate amongst the FOMC was to raise rates four times in 2016. This assessment was derailed quickly when global stock markets took a dive over the first two months of 2016 due to global growth concerns. Since then the FOMC has yet to raise rates this year and has further revised down their median assessment for rate increases through the end of 2018.
This reflects a belief amongst the Committee that lower levels of global growth may continue. As noted at the September 21st meeting, inflation remains below its 2% target and longer-term inflation expectations are little changed. Corporate earnings have remained subdued and central banks across the globe continue to favor low, and in some cases negative, short-term interest rates. Bond markets seem to agree. Yield of long-term treasury bonds, generally a good indicator of the bond market’s long-term interest and inflation rate expectations, has remained historically low.
That said, the tone of the FOMC’s recent meeting seemed optimistic. Overall, domestic economic trends continue to head in the right direction. The unemployment rate has fallen to the lowest level since before the recession in 2007. Wage growth has picked up and household spending has been growing strongly. These indicators even led three Committee members to break rank with the rest of the Committee and vote in favor of raising rates now. Overall, a majority of Committee members expected to raise their benchmark rate at least once this year.
It is apparent amongst these conflicting indicators that the Committee, although seemingly more positive, remains cautious. With rates this low, there is some worry that there is little room to ease if current economic conditions falter. Overall the economy still remains fragile, though, and a majority of Committee members seem to believe that it will be easier to respond to faster inflation than to an economic downturn.
A more aggressive approach to interest rate increases may also be unwise because in many respects recent policy appears to be working. In accordance with the Federal Reserve’s statutory mandate to foster maximum employment and price stability, the last several years have been remarkably stable. We have seen the labor market gradually improve while inflation has remained sluggish. Surprisingly to some, the seven-year period since the end of the Great Recession has become one of the longest economic expansions in American history. It has also been underwhelming and slower than many forecasters, including those within the Federal Reserve, expected.
It appears that the decision makers in the Federal Reserve may be increasingly open to the view that we are in a ‘new normal’ economic environment predicated on low growth, low interest rates, and low inflation. Factors such as lower productivity, increased globalization, and an aging population have combined to create a growth environment different than what we may have been accustomed to in the decades before the turn of the century. This could be why the FOMC has been able to hold rates so low for so long and not had the economy overheat.
This view is not exclusive to the Committee. When the FOMC ‘increases rates’ they have a direct effect on short-term rates by increasing the supply of short-term interbank loans. This decreases the demand for short-term debt, thereby raising the yield on these securities. Quite tellingly, though, directly after the FOMC last decided to raise rates in late 2015, demand for longer-term treasury bonds actually went up, pushing their yields down. Despite the hubbub over every slight uptick in short-term rates, the market consensus still clearly favors our current environment continuing for some time.
In this environment, our job as advisors remains to help our clients reach their financial goals. We, like the FOMC, remain optimistic that the economy and financial markets will continue to heal after the Great Recession. We anticipate that interest rates will continue to rise, albeit slowly, and the stock market will continue to be important to long-term portfolio growth. Understanding what market challenges may lie ahead, as well as finding new sources of portfolio return, will be important as we move forward.
ARTICLE WRITTEN BY:
Timothy S. Hamilton, CFP®
Vice President and Wealth Management Advisor
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