Ever since the Great Recession of 2008, the Federal Reserve has been buying bonds at a rapid pace and lowering interest rates to historic levels. As the economy has picked up over the course of the last several years (in terms of GDP growth, job growth, and equities), the Fed has slowed down the purchasing of bonds to nil, but the interest rate has been at a trough for the longevity of the recovery. Many professionals on Wall Street have called for Fed Chairwoman Janet Yellen to raise the rates, yet she has been cautious in doing so, citing the lack of inflation (especially wage inflation) and global economic conditions as the reasons for the delay. Fed Statement
The new norm for Fed policy is slow actions. Any word said during Fed minutes can move the markets drastically. Therefore, whatever and whenever the Fed decides to change the status quo, they should do so slowly and with caution. Many investors expected the interest rate to rise in June or September. That was the consensus sentiment from Wall Street since Yellen seemed to be running out of reasons for further delay. However, the rise in rates will not occur as rapidly as most would assume, and even if so, would be a very small rise over a long period of time. Here is the rationale.
1. Divergence with the Global Economy:
The dollar has strengthened of late against most currencies in the world. This is due to the divergence in central bank policy. The US has already participated in rapid quantitative easing, whereas most of the world is just starting. Japan, the Eurozone, Australia, Canada, and even China have recently tried to stimulate growth through currency manipulations. This has caused the appreciation of the dollar resulting in less exports of US goods from multinationals in the US. If the Fed were to increase rates during this crucial period, the dollar would strengthen further, leading to additional burdens to these US multinationals. This could stifle growth and hurt the US equity markets.
2. Disinflationary Threats:
Although the global economy is facing deflationary threats, the US is facing disinflationary threats. Oversupply of commodities, especially oil, due to advances in technology have led to falling commodity prices across the board of commodities. This results in lower prices and contributes to the slowing growth of inflation. In order for US interest rates to rise, inflation must lead it higher to encourage investments. Although job growth has picked up of late, increases in wages is nonexistent. If rates were to rise, it would be more costly for borrowers plus their wages and disposable income would be low, further hampering investment and growth.
3. No Guidance of Policy in the Eurozone:
Germany is failing to invest, hurting Eurozone growth prospects and contributing to deflation. Additionally, the austerity limit placed on Greece is being rebuffed by Syriza. The new debt deal with reforms promised has been further delayed 4 months. Negotiations of this magnitude usually are solved last minute. The next Fed meeting is 4 months from now as well. The Fed cannot make a move as drastic as raising the interest rate if they do not know how the Germany-Greece deal will pan out. Every negative/positive implication coming out of the debt talks has caused volatile moves in US equities. The Fed must carefully time its raising of rates.
A rising interest rate would be healthy for the US economy. However, the timing needs to be right and the move needs to be gradual as not to shock the markets and hurt the successful US growth story. Steady as she goes Chairwoman.