After a Smooth Rate Liftoff, the Hard Work Starts for the Fed
Janet Yellen’s careful signaling ensured a strong market reaction to Wednesday’s hike, but the road ahead contains plenty of potential pitfalls.
If there were futures in Janet Yellen, the price would be through the roof.
The Federal Reserve chair pulled off the biggest shift in monetary policy in nearly a decade on Wednesday, and instead of triggering uncertainty and instability she had the market eating out of her hands. Yes, the quarter-point hike in the federal funds rate was small in magnitude, but it is huge in significance. It brings an end to seven years of zero interest rates, an unprecedented period in American financial history.
For years hard-money types have warned that the Fed’s easy-money policies would end in a surge of inflation and a debasement of the dollar. Others cautioned that a premature rate hike could tip the economy back into recession or trigger a massive flight of capital out of emerging markets. That was no idle risk considering that Yellen’s predecessor, Ben Bernanke, unleashed months of market turbulence — the infamous “taper tantrum” — back in 2013 merely by suggesting that the Fed might reduce its then-massive purchases of government bonds.
Yellen learned well from that experience. Ever since the Fed ended its quantitative easing program in October 2014, she has given increasingly specific guidance about the economic conditions — a stronger labor market, inflation heading back toward the Fed’s 2 percent target — that would warrant a rate increase. When market jitters picked up after a sudden Chinese devaluation in August, and led two Federal Reserve Board members to question the need for a rate hike, she kept her cool and indicated that the central bank was on track to tighten by the end of the year. As U.S. job growth accelerated in September, October and November, other Fed members came back onto the rate-hike bandwagon.
Yesterday the Fed delivered the most well-telegraphed policy shift in memory, raising the federal funds rate to a range of 0.25 to 0.50 percent and signaling that future hikes would be gradual, and contingent on inflation actually picking up. The so-called dot plot of Fed members economic forecasts indicate the central bank will raise rates four times both next year and in 2017.
Wall Street couldn’t have scripted a rosier tightening scenario. The dollar and U.S. Treasuries held rock steady on the news, with the ten-year yield at a modest 2.30 percent; the Standard & Poor’s 500 index jumped 1.45 percent, and the VIX — the volatility index that’s often called the market’s fear gauge — dropped nearly 15 percent. “The Fed’s got to be really happy with how the market has handled the announcement,” says Michael Collins, a senior investment officer and credit strategist at Prudential Fixed Income, a unit of the big U.S. insurer.
Yellen better enjoy this moment because the road ahead is filled with potential pitfalls. The first concerns markets themselves — years of zero rates and QE-inflated asset prices in the U.S. and around the world — and no one knows for sure what stress could break out in a rising interest-rate environment. Just ask Marty Whitman, the legendary investor, whose Third Avenue Management last week announced it would liquidate its Focused Credit mutual fund because of a massive selloff in the junk bond market. Many investors piled into illiquid assets in recent years in a desperate search for yield; a generalized rush for the exits could get ugly.
Then there’s the economy. Yellen justified the hike by saying the outlook for sustained growth and employment gains remained solid while the Fed was confident that inflation would return to its 2 percent target before too long. None of those outcomes are in the bank.
The global economic outlook has continued to weaken in the latter half of 2015. China’s economy remains soft and Beijing has just revised its currency basket, making it more likely the renminbi will decline gradually against the dollar over the coming year. A fresh drop in oil prices is hammering producers from Russia to the Gulf to Venezuela without providing much of an offsetting lift elsewhere. And a general strengthening of the dollar, which is baked into most economists forecasts for 2016, would create headwinds for U.S. growth.
Inflation continues to run well below the Fed’s target rate. Consumer prices rose by just 0.5 percent in the past year, while the inflation rate for personal consumption expenditures — the Fed’s favored measure — is just 1.3 percent. Fed members believe continued growth and an unemployment rate dipping below 5 percent should put upward pressure on wages and prices, but Yellen acknowledges that if inflation doesn’t climb back toward the Fed’s 2 percent target, that would “give us pause.”
The big fear is the specter of Japan. A decade ago the Japanese central bank raised rates, believing the economy was on the mend, only to have to cut them back to zero again and embark on a new round of quantitative easing. Sweden hiked rates aggressively in 2010 and 2011 when the recovery appeared solidly on track, only to have to reverse those moves. Today that country has negative interest rates.
The Fed’s forecast of four rate hikes in 2016 is not fully shared in the markets. Bond markets seem to be pricing in two or three hikes; most economists see three or four. But confidence levels aren’t great. The U.S. recession was the worst since the Great Depression; the recovery has been the weakest in the postwar era despite unprecedented monetary stimulus. No one is really sure how the economy will react as that stimulus is withdrawn.
Prudential’s Collins, for one, is skeptical; he thinks it’s unlikely the Fed will succeed in getting the federal funds rate up to 3.5 percent, its current estimate of the appropriate long-term level. “There’s a really good chance they’ll cut before they get to 2 percent,” he adds.
Getting rates off zero is welcome news, for the economy and financial markets. Keeping them there would be better news still. For Yellen and her colleagues, the toughest job is yet to come.
Follow Tom Buerkle on Twitter at @tombuerkle.
Get more on macro .