Stay Seated Until the Economy Reaches Cruising Altitude

The U.S. economy is airborne, but it’s not at cruising altitude yet. That’s why I’m betting our policy pilots at the Federal Reserve, which meets mid-month, will decide to continue the ZIRP (zero interest rate policy) a while longer.

zero-percentWhat should you do about it? Zip! Keep your seatbelt on, and tune out the nattering of the fellows in the row behind you (or the pundits on TV) who think they know how to fly the plane better.

Why do I think ZIRP will live on? Well, most recently, the initial revision to first-quarter economic growth figures signaled that our marginally positive GDP actually contracted by 0.7%. Inflation is being held down by lower energy costs, and while oil prices have stabilized recently, they are still meaningfully lower than a year ago.

Headline consumer price index (CPI), which includes energy prices, is down 0.1% over the past 12 months. The Fed’s preferred measure of inflation, core personal consumption expenditures (PCE), has been remarkably stable around the 1.5% level for nearly three years.

Despite savings at the pump, consumer spending remains lackluster. For a data-dependent Fed, the data doesn’t signal a need to change course.

Vanguard economist Joe Davis agrees, telling Bloomberg that central bankers will begin raising the fed funds rate in September and will stop when that rate hits 1%, sometime in 2016. “The ceiling is 1%,” Davis says. “[The Fed] may be hard pressed to get above 1% over the next three years.”

While Davis is probably right on the September call, I’m not so sure about his prediction of where the data will take us; it’s a stretch to say the funds rate will top out at 1%.

It actually could top out much lower if continued slow growth overseas and greater dollar strength saps growth here in the U.S. Whichever way it goes, even a 1% fed funds rate means interest rates will remain exceptionally low — far from anything resembling “tight” interest rate policy.

Editor Dan Wiener and Research Director Jeffrey DeMaso publish The Independent Adviser for Vanguard Investors, an award-winning monthly advisory letter that keeps subscribers abreast of recent developments at Vanguard, and provides long-term guidance for investing in the Vanguard fund family.

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