The Fed

By David B. Armstrong, CFA | Sep 15, 2015 | Weekly Market Commentary

This week it’s all about the Federal Reserve.  Their two-day meeting will finish up on Thursday and it is the first meeting in almost a decade that could bring about a hike in the fed funds rate.

How Fed Chief Janet Yellen frames the decision may be just as significant, if not more significant, than what the Fed finally decides. And frankly, it’s the trajectory of rates over the next couple of years that should be the focus rather than this one event.

However, no matter what, expect a volatile day.  The best advice is: DON’T DO ANYTHING.  You have your plan and it does not include trying to guess about things like this.  Leave the guessing to the talking heads paying thousands of dollars to PR firms to get them on CNBC.  They are playing a different game – don’t get swept up in it.

So let’s look at both sides of the coin: why rates should raise and why they should stay the same.

First, why should the Fed raise rates at the September meeting?

1. The economy is at full employment and the fed funds rate is still near zero. The August jobless rate of 5.1% is in the middle of the Fed’s full employment sweet spot range of 5.0 – 5.2%.
2. The rate we have right now is an “emergency rate.” We’re beginning year seven of the economic recovery / expansion and the Fed has yet to boost rates. That’s a long time at an “emergency rate.”
3. We don’t need a bubble. These low rates coupled with an economic expansion can encourage bubbles and instability as consumers, businesses and investors make decisions based on artificially low rates.
4. Let’s face it … even with a 0.25% hike, policy remains quite easy. The U.S. economy accelerated in the second quarter so it can probably handle a 0.25% rate hike.
5. A cloud of uncertainty over markets would be lifted as the Fed finally found the courage to pull the trigger, even if baby steps are the most likely path. It would likely be viewed as a sign of confidence in the economy by the Fed.
6. There is some evidence of wage pressures caused by labor market tightening. This is often seen as a precursor to inflation.

Now, why should the Fed hold off and leave rates unchanged?

1. Inflation has failed to move up to the Fed’s target of 2%, commodity prices are suffering near 15-year lows (you’ve been to the gas pump, right?), and inflation expectations have also fallen.
2. Rising rates may attract additional foreign funds, which could further boost the value of the U.S. Dollar and compound headwinds for U.S. exporters and manufacturers. Go back to blogs I wrote around the end of the first quarter of 2015 to see the corporate profit woes blamed on the rising U.S. Dollar.
3. The unknown impact of a rate raise given financial instability and problems in China.
4. There are ten Fed officials that vote at each meeting and the ‘centrist’ ones have become more reluctant to support a September rate increase.  It’s not a GREAT reason to leave rates unchanged but it happens to be a reason.
5. 62% of analysts do not expect a September rate hike per the latest CNBC survey.  Who likes surprises?  The Fed typically likes to avoid surprises.
6. A rate hike might exacerbate financial market instability, especially in emerging markets.  The International Monetary Fund has asked the Fed to hold off until next year, and the World Bank warned last week of “panic and turmoil” in emerging markets if the Fed hikes.  So you know, there’s that.
7. We still have two more meetings (October and December), in which the Fed could act this year. December is less likely than October if they leave rates unchanged this week … no one wants to mess with holiday sales.

The Bottom Line

The uncertainty surrounding the upcoming meeting is in contrast to signals in July and early August, which suggested a consensus was forming at the Fed to raise rates this week.  The correction in stocks and uncertainty in China and emerging markets are to blame for the shift. Nevertheless, you can see that a case can be made for either scenario.

There will never be a perfect time to start raising interest rates, but the uncertainty in today’s global environment gives central bankers plenty to chew on at the two-day meeting.

Again, your game plan should be to do nothing.

Call with questions or concerns.

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