Will the Federal Reserve raise interest rates when it meets in September, or will it continue to hold rates near zero?
Whatever the the Fed decides, you need to understand the impact, if any, on markets and your portfolio.
While these questions cannot be answered with certainty until the Federal Reserve actually raises rates, there are some basic things to know that will help you make informed decisions with your money.
Let’s start with a little refresher on monetary policy in the past few years with two words — quantitative easing.
When the Fed ran out of standard monetary policy tools to stimulate the economy in the wake of the credit crisis of 2007, it began the first of three rounds of QE in 2008, during the peak of the financial crisis.
The last round of QE ended in 2013, when the Federal Reserve chairman at the time, Ben Bernanke, announced that a “tapering” of QE would begin once certain economic conditions had improved. The tapering ended in October 2014. And since then, the Fed and new chairwoman, Janet Yellen, would pause on its first interest rate hike at subsequent meetings, leaving investors to play a guessing game as to when that normalization of monetary policy would begin.
Reasons the Fed Rate Hike May Be Deferred Until Later
The Federal Reserve wants to see two things happen before it raises rates: full employment and signs of positive inflation. Unemployment sits at a healthy 5.3%, which can be considered full employment, but inflation remains under the Fed’s 2% target. Technically, the tame inflation is enough reason to wait for a rate hike.
Here are other factors that are potential reasons to delay a Fed rate hike: The yield curve has flattened, the dollar is strong, oil has fallen dramatically in price, employment gains have leveled off, gross domestic product growth has slowed and there has been volatility in the global economy and financial markets since the Fed’s July meeting.
From this perspective, a Fed rate hike could potentially be harmful, because it would contribute to strengthening of the dollar, put more downward pressure on oil prices and weaken housing and consumer sentiment.
Also, from a non-quantitative perspective, comments coming out of previous Fed meetings have trended toward raising interest rates by the end of 2015, but September was never carved in stone. The loudest voices on the September prediction have come from analysts and media pundits, not the Federal Reserve Board of Governors nor Janet Yellen.
And although the Fed does not exist to support capital markets, there is concern about causing an overreaction in financial markets as in the past. Stocks and bonds suffered sharp declines in 2013 when the Fed arguably botched its communications about when it would begin slowing its QE bond purchasing program.
Why a Fed Rate Hike Will Happen in September
On the one hand, economists and Fed watchers who think the Federal Reserve will act in September point to the low unemployment rate and strength in housing and consumer spending, building up steam for stocks like Lennar (LEN) and D.R. Horton (DHI).
On the other hand, there’s the opposite concern that keeping rates close to zero for too long may create dangerous bubbles in stocks, bonds or other assets. A short-term dip in stock and bond prices is less of a concern than the macro picture going forward.
On the low inflation argument, it remains below the Fed’s 2% target. But the Federal Reserve has indicated it would like to be proactive in keeping a lid on inflation. A rate hike in September would be a preventative measure, and could therefore come before inflation has a chance to get out of control.
Also, part of the slowdown in inflation is the huge decline in oil prices over the past year, which has decimated energy stocks like Exxon Mobil (XOM) and Chevron (CVX). The downward pressure on oil will eventually reverse itself, which would fan the flames of inflation. Therefore, the Fed would be arguably irresponsible to wait for oil prices to rise before its next rate hike.
Yellen has stressed that when the Fed begins to raise rates, it will do so gradually. Leaving low borrowing costs in place could avoid weakening the economy. Raising rates in small increments, followed by pauses, will allow the Fed to methodically assess its forward-policy impact on the economy. This reasoning, even after considering reasons to pause, rings sound.
Bottom Line for Investors on a Fed Rate Hike
There are just as many reasons for the Fed to pause in September as there are for implementing the first rate hike in nine years. But for the majority of investors, an increase in interest rates is not a cause for concern.
A rise in interest rates is a signal that the economy is strengthening, and global markets could react negatively if investors perceive that the Fed is behind the curve on monetary policy.
Also, it is likely that a Fed rate hike is mostly priced into stocks and bonds now. Any decline in securities prices, barring any other unforeseen economic challenges, would likely be short-lived.
Kent Thune is the owner of an investment advisory firm in Hilton Head Island, South Carolina. Under no circumstances does this information represent a recommendation to buy or sell securities.
