Not long after the Federal Open Market Committee’s Jan. 31 meeting and the entrance of new Fed Chairman Ben Bernanke, the interest-rate consensus rapidly shifted. Instead of the expectation that the Fed would curtail the rate hikes with the March 28 meeting, the notion took hold that interest rates would be rising, along with the temperatures throughout the spring and perhaps into the summer.
In early March, Lehman Brothers raised their fed funds forecast to 5.5 percent.
“There will be at least three more rate increases, maybe four or five,” Edgar Peters, chief investment strategist for PanAgora Asset Management, was quoted as saying in the March 13 edition of The Wall Street Journal.
Richard Bernstein, chief U.S. strategist for Merrill Lynch, said at a Feb. 2 financial roundtable, “And I think there’s a big risk looking forward over the next several months that the Fed will tighten more than people anticipate.”
Even the 10-year Treasury note suddenly bounded higher, pushing long-term interest rates to the highest point since the Fed began raising rates in June 2004.
Yet a moderate reading on the February consumer price index, released March 16, has served to dial down some of those expectations in recent days.
As we get closer to the culmination of interest rate increases, why are the details of the Fed’s campaign so foggy? The Fed openly admits that incoming economic data carries significant weight when assessing the economy and the need for additional interest rate hikes, just as an outdoor wedding in the works for a year can be shifted indoors at the 11th hour if rain showers threaten.
The Fed’s dependence on incoming economic data can be both a blessing and a curse.
Incoming data may be the closest things to real-time economic reads. But the economic strength evidenced by that information may mask the true sensitivity of consumers and the broader economy to something such as a sharp correction in housing. Or some large-scale financial meltdown in the hedge-fund world, not unlike the collapse of Long Term Capital Management in 1998, may suddenly surface in response to a pronounced increase in long-term interest rates.
In either case, the justified Fed actions of today could be what trips up the economy tomorrow.
Surely no one is more aware of the dire economic consequences of overtightening than the FOMC members themselves, you might say. And you might be right. Or at least that is the message the Fed seems to be trying to communicate. San Francisco Fed President Janet Yellen said in a March 16 speech that she would “be sensitive to the possibility that policy could overshoot.”
There are real consequences of overtightening. Higher interest rates could lead to a drastic slowdown in borrowing and a similar deterioration in credit quality as delinquencies and defaults increase. Tighter lending standards would constrain economic growth, hurting both household and corporate balance sheets, both bond and stock markets alike. But get it right and the Goldilocks economic prosperity resumes — buoying the stock market, averting a bond market bloodletting, with growth in jobs and consumer spending continuing.
As far as the moderate February inflation readings that have tempered expectations, this is the kind of incoming information the Fed will need to see if the rate hikes are going to end sooner rather than later. It’s just that the Fed will need to see more of it — with a consistent drumbeat of tame inflation pressures the necessary ingredient to send the Fed to the sidelines and keep them there.
As the Fed’s path becomes clearer, we can expect a healthy dose of market volatility in both stocks, which are at five-year highs, and bonds that are fickle in the face of anything dealing with inflation and Fed rate hikes.
One certainty is that no matter how long or short the Fed’s rate-raising campaign, cash investments such as money markets and CDs will continue to blossom.