Federal Reserve action stirs policy error concerns
Timeline for raising rates has become more murkyNovember 5th, 2015
Much anticipation and discussion swirled throughout the summer regarding when the Federal Reserve would begin the process to normalize interest rates, with economists and forecasters pretty evenly split between whether or not the Fed would start in September or December.
Although the Fed’s lack of movement on the process in September wasn’t entirely unexpected, the rationale behind the decision to maintain the status quo was received with surprise and prompted questions about a policy error.
When the Fed announced its decision, the reasons given were concerns over global economic growth and volatility in the financial markets. Although these issues may, in fact, be of concern, they aren’t a part of the Fed’s mandate, which is to create full employment and stable inflation. From that standpoint, many argued that the Fed had sufficient reason to begin the process of raising interest rates in September.
The employment picture in the U.S. has shown signs of strength. The unemployment rate has steadily declined, including the all-inclusive U6 measure, which incorporates those officially categorized as unemployed, those who are marginally attached to the workforce, and those who are working part time but want full time jobs. Jobs creation has been steady as well.
More importantly, the Fed spent most of the summer telling the financial markets that the goal of full employment was close enough to potentially warrant a rate increase.
The Fed also spent time and effort communicating its belief that the declining inflation rate was due to a transitory event—oil prices—which would wash out by the end of the year. Based on the official comments and communications from the Fed, most businesses and investors were prepared for a rate increase in September.
Given the economic indicators that appear to be in place for a Fed Funds rate increase and the Fed’s rationale incorporating elements beyond its scope, an argument could be made that the Fed has committed a policy error. Further, if global events and market volatility are considered in the Fed’s decision-making process, it begs the question of what other factors might play a role in the future.
The fallout of the Fed’s action—or inaction, as the case may be—is the challenge of maintaining credibility. For nearly two years, the Fed has been telling the business and investment world that it’s preparing to raise rates. As each Fed meeting goes by and nothing happens, there is a risk of being viewed as the boy who cried wolf.
More importantly, if the business and investment world conclude that the Fed can be influenced by factors outside of its mandate, then the Fed could be portrayed as no longer exercising independent decision making. In addition, businesses and investors could lose confidence, thus hindering the Fed’s effectiveness.
Although policy changes may appear far removed from the local business community and individuals, the Fed’s actions reverberate throughout the financial system. For instance, a zero interest-rate environment often results in a misallocation of capital. In the current low-rate environment, publicly traded companies have been issuing debt and using the proceeds to buy back stock or issue special dividends, rather than invest in plants and equipment. This strategy reaps a short-term benefit of boosting the stock price, but does nothing to ensure long-term competitiveness. If anything, it may cause management to maintain a short-term focus, particularly if compensation is tied to the company’s stock price.
For smaller, privately-held companies, a persistent zero interest-rate environment may mean a reduced ability to borrow. Financial institutions continue to face profit margin compression because, as of yet, U.S. financial institutions haven’t convinced depositors to accept negative deposit rates.
As a result, financial institutions can’t lower their borrowing cost (i.e. deposit rates) to offset the steady decline in lending rates that occurs as older, higher yielding loans mature and are replaced with loans made at today’s low interest rates.
Financial institutions that don’t have other income sources (i.e. mortgage lending, brokerage, trust and wealth management services, etc.) to offset declining loan income are most at risk and could be problematic for small businesses seeking a borrowing source.
On top of that, new regulations may require financial institutions to hold more capital for the types of loans that small businesses need, thus discouraging this type of lending.
For many individuals, the zero interest-rate environment has forced them to seek greater returns for their capital in investments outside their comfort zone. In this rate environment, the flow of money into mutual funds largely has been directed into higher-yield, higher-risk asset classes.
Worse, the mentality has developed that “the Fed has my back.” As each month goes by, investors may become complacent and lose focus on the second part of successful investing: risk management. The longer the Fed leaves rates unchanged, the more investors may increase their risk exposure while seeking to maintain income. This practice may provide short-term benefits, but may result in long-term damage if investment portfolios aren’t positioned to weather financial market downturns.
The timing of when the Fed will begin the process of normalizing interest rates is now far murkier, thanks to the recent consideration of factors beyond its mandate. As it stands, the financial markets have lost faith that the Fed will act this year—although December is not completely ruled out—and are anticipating the first increase to occur in the first quarter of 2016.
If the economy continues to show progress, financial market volatility decreases, and global economies indicate improvement, the Fed may raise interest rates by the end of this year to help credibility. Unfortunately, businesses and individuals continue to run the risk of becoming distracted by the Fed’s potential actions and possible new criteria at each meeting (approximately every six weeks) rather than focusing on what makes them or their businesses successful.
Steve Scranton is the chief investment officer and economist for Spokane-based Washington Trust Bank.