To raise or not to raise…
That is the dilemma at the Federal Reserve.
For the first time in nearly 10 years, the Federal Reserve raised interest rates by 0.25% in December 2015 – a strong indication the central bank was confident about the strength of the U.S. economy and its ability to handle higher borrowing costs.
That optimism was a bit premature, though. The U.S. economy wasn’t ready.
Markets would plummet shortly after. Gold soared. Investors tightened their belts on fears of a recession. Trillions of dollars were wiped out in weeks.
Now, five months later, interest rates have stayed put.
In April, the Fed left rates unchanged, noting that the U.S. economy had slowed and that consumer spending was soft. Coupled with a weak global economy, the Fed had more than enough reason to remain cautious moving forward.
But that all changed May 18 when the Fed hinted at another rate hike by June 15, 2016.
Of course, fear spread like wildfire that, if we increase borrowing costs too soon, the Fed could tip the U.S. economy into recession and drag the global economy with it.
Still, Jeffrey Lacker, president of the Federal Reserve of Richmond noted, “It looks to me as if the case for raising rates looks to be pretty strong for June. Inflation is moving decidedly toward 2 percent. Labor markets have tightened significantly. The concerns, the downside risks we saw at the very beginning of this year, have dissipated.”
And, despite poor GDP growth of 0.5%, no real wage growth, and recently disappointing unemployment data, even John Williams, president of the Federal Reserve of San Francisco believes the U.S. economy is gaining strength. However, even he admits that there are risks to the global economy, including a potential Brexit, which would “spill over into global financial markets,” he notes.
In the minutes from the last FOMC meeting, “most participants” noted a June hike would be “appropriate” if the economy continues to improve. Higher rates have broad support inside the Federal Reserve, it would seem.
But an increase is contingent on economic growth picking up in the second quarter; labor market conditions continuing to improve; and inflation making progress toward the 2% objective. However, if inflation were a threat, that would be a great reason to increase rates. But as the last minutes noted, inflation is still below the 2% target, expected to remain at an average rate of 1.75% over the next 10 years.
While the Fed members may cheerlead economic progress, there are plenty of reasons why the U.S. cannot handle a June 2016 hike, including anemic GDP growth of 0.5% in the first quarter of the year.
U.S. jobs growth is weak. Headline unemployment of 5% leaves off millions of Americans that gave up looking for work. The ratio of business inventories to sales has risen significantly. Retail sales are poor.
Many Americans are drowning in debt with flat wage growth concerns. That, coupled with a weak global economy, shows that we’re not prepared for higher rates. There’s also growing fear that if the Fed raises rates even more, consumers will be forced to pay higher interest on loans. If that happens, consumers could begin to spend less money as a result.
At the moment, there is a 38% chance of a rate hike at the June 2016 meeting, a 60% chance of a hike in July 2016, and a 72% chance for a September 2016 hike.
Unlike last December, when the rate increase shocked the market and caused it to plunge, this time the market is ready. If we see a hike in June, I think the impact will be a brief pullback because the market is well aware of the potential for a rate increase.
Whatever the case may be, we’ll find a way to profit from it.