The Fed's 'close call' on interest rates

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Newly released minutes from the Federal Reserve’s September meeting say the decision to leave interest rates unchanged was a “close call.” It’s the latest indication, along with public comments from Federal Reserve Board Chair Janet Yellen and others, that another rate hike is coming.

“The minutes offered no clues into the timing for the next rate increase as several members indicated a rate increase was warranted ‘relatively soon,'” says John Bredemus, vice president of Allianz Investment Management.

A written statement released immediately after last month’s meeting provided earlier evidence of a more contested debate. Members voted 7-to-3 in favor of maintaining the federal funds rate at its current level — an unusual, but not unprecedented divide.

Perhaps bolstering the case for a rate hike before long, the Labor Department recently reported that the U.S. economy added 156,000 jobs in September. Average hourly earnings have risen 2.6% over the past year.

The Fed’s policymaking Federal Open Market Committee last raised rates in December 2015. The betting in financial markets and among experts is that the next rate hike will happen once the outcome of the November election is resolved. A rate increase was thought possible earlier this year, but the FOMC hesitated before the surprising vote in the U.K. to exit the European Union, which unsettled stock markets for several days.

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Fed’s dual mandate: jobs and price stability

While the economy is widely thought to have met the Federal Reserve’s goal of “maximum employment,” with the jobless rate at 5% or less in recent months, the minutes note that inflation has yet to rise toward the Fed’s 2% target.

“There was general agreement that the labor market continued to head in the right direction. However, there was less agreement about the amount of labor market slack remaining,” says Gus Faucher, deputy chief economist with PNC.

While the number of jobs added in the U.S. this year will likely fall below last year’s level, some of that is seen as resulting from a tighter job market. On the other hand, a lack of more substantial wage growth, which otherwise would help foster inflation, is seen by some as a sign that there’s more job market slack remaining.

The divide over the risk or status of price stability, or inflation, might well be what separate FOMC members as they consider whether to raise rates. The minutes note that several officials commented about forces possibly restraining inflation, including “the limited evidence of rising cost or price pressures, the apparent low responsiveness of inflation to the rate of labor utilization, a possible downward shift in inflation expectations, and remaining economic slack.”

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What are consumers, investors to do?

The best bet for now continues to be that the Fed will hike short-term rates at the meeting set for December 13-14. That means borrowers should anticipate the possibility that borrowing get a bit more costly, via everything from credit cards, auto loans and home equity lines of credit. Savers might also get a much-needed boost in returns on their 1- and 5-year certificates of deposit, which have been stuck below 1%, on average.
As for stock market investors, how the market reacts to the meeting minutes could provide some indication.

“The areas of the equity market that stand the most to gain from a rate hike, e.g. banks and insurers, also turned higher (Wednesday), and despite lagging the daily gains of real estate and utilities, continue to be month-to-date winners,” says Chris Zaccarelli, chief investment officer with Cornerstone Wealth.

If the current outlook for a possible rate hike remains intact, Zaccerelli adds, “investors will continue to benefit from a sector rotation into financials and away from utilities. High-yield bonds will continue to do well as long as the equity rally continues, and better earnings will continue to drive stocks higher as long as interest rates are perceived to be rising at a slow pace.”
On the other hand, if what now seems unlikely were to materialize and Federal Reserve officials find a reason to avoid a rate hike before the end of the year, it shouldn’t come as a huge shock. They’ve decided to hold off repeatedly in recent years, helping to explain why rates remain just a tick above record low levels.

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