Will Fed Go All-In With Rate Increase?
To put this in perspective, the last time the Fed raised rates no one had an IPhone; Alan Greenspan was still being lauded as a Maestro for his stewardship of the Federal Reserve Board, which had recently been taken over by this guy named Ben Bernanke; Bernie Madoff was an investment genius, A-Rod didn’t take steroids and your faithful blogger had hair – kind of. Back then, the Fed raised the Fed Funds Rate 25 basis points to five and a quarter percent because “inflation fears” remained.
Who ever said the more things change, the more they stay the same was, of course, dead wrong. Now that the Fed has raised rates the new questions upon which to speculate are: How quickly will the Fed raise interest rates? By how much? The most unequivocal thing I will say in this blog is that now that the Fed has decided to raise rates it makes no sense to stop at 25 basis points. For my money we are looking at a series of raises that will raise rates by at least a point over the next year. The Fed has made its bet and now must play out its hand.
Allow me to digress.
I love poker. The most challenging hands to play are the ones that could go either way. Let’s say you are dealt a pair of eights with five cards left to be dealt. If you don’t bet too low you are inviting people to stick around and get one more card that might beat your hand; if you bet too much and someone calls you might find yourself losing a bunch of money when every subsequent card is higher than an eight.
The Fed has one of those high-risk/ high-reward hands that could go either way especially since it has a twin mandate to help maximize both employment and price stability. Look at the Fed’s hand: Unemployment is down to levels at which you would expect to see the Fed raise rates. After all, at some point all these newly employed workers have to put sustained upward pressure on wages, don’t they? Besides, all this cheap gas should boost spending even though it hasn’t had much of an impact yet, right?
Conversely, inflation is actually too low and shows no signs of taking hold in the near term. Janet Yellen must decide how much to bet in the form of higher interest rates: too low an increase and she has done nothing to tamper the possibility of the median term inflation spike that the Fed has decided must be guarded against; too big a raise and she might do more harm than good by stifling growth; sending the bond market tumbling and laying the groundwork for the next recession. It’s a tough call but the worst thing she could do is not act decisively.
In a speech in September signaling that rates would be on the rise by the end of this year, she explained all this not by talking about poker but by explaining that “[b]y itself, the precise timing of the first increase in our target for the federal funds rate should have only minor implications for financial conditions and the general economy. What matters for overall financial conditions is the entire trajectory of short-term interest rates that is anticipated by markets and the public.” In the same speech, she commented “[i]f the FOMC were to delay the start of the policy normalization process for too long, we would likely end up having to tighten policy relatively abruptly to keep the economy from significantly overshooting both of our goals. Such an abrupt tightening would risk disrupting financial markets and perhaps even inadvertently push the economy into recession.”
What does this mean for you? I was talking to a credit union executive the other day and I assumed wrongly that a rate hike would automatically be welcomed news. Not necessarily. The executive pointed out that if rates get too high, members might start shopping around for better rates. While the big guys might be able to absorb the cost of higher interest payments, many medium size and smaller ones might be further squeezed. Remember that the majority of credit unions lost members last year.
At what point will this increasingly fickle lot click on their iPhones and start searching for better rates? No one knows, but if I’m right the Fed is going to make it more tempting for them.