Economic Insights - December 14 - 18, 2015
The First Rate Hike
The Fed did the deed. The last time the Fed raised rates was so long ago, the iPhone hadn’t even been released yet. So, the Fed made history this week when it raised the target range for fed funds. It was seven years to the day after the Fed cut rates to zero for the first time in the face of the worst financial crisis since the Great Depression. A big short-covering rally followed the Fed’s announcement, but worries about a soaring dollar, global recession, and a hard landing in emerging markets flared Thursday and Friday and markets tanked.
What Did the Fed Do?
In all, the Fed took five steps, which were implemented the day after the meeting:
- Raised by 0.25% the interest paid to banks on their excess reserves (IOER) to 0.50%.
- Raised the interest the Fed would pay on its reverse repurchase agreements (RRP) to 0.25% from 0.05%. Taken together, the IOER and RRP make the upper and lower bound of the new range for fed funds: 0.25% to 0.50%.
- Will continue to reinvest the principal payments from its holdings of Agency and Treasury debt “until normalization of the level of the federal funds rate is well under way.”
- Raised the discount rate from 0.75% to 1%, which is the rate at which banks can borrow from the Fed overnight.
- Expanded the total amount of RRPs permissible from the current $300 billion limit to a total limited only by the value of Treasury securities held in the System Open Market Account(SOMA) and subject to a counterparty daily limit of $30 billion.
That last point was key as analysts wondered how the Fed would keep the funds rate within the desired range since money market funds could willingly lend billions to banks at rates below the 0.25% minimum. The cash in those funds does not qualify for the 0.5% rate paid to banks on excess reserves, so the funds must seek whatever return they can get. To sop up that excess, the Fed can use the roughly $2.5 trillion in its SOMA for the RRP operation. That’s why the nearly unlimited uptake in the last bullet was so important to help the Fed keep the funds rate at or above 0.25%. In fact on Thursday, the Fed needed only $105 billion in RRPs to take up excess cash; on Wednesday, it needed $102 billion to keep the rate at 0.05%. For all the talk about the challenges the Fed would have, the actual funds rate on Friday was reported at 0.36%, according to published quotes from the world’s largest inter-dealer broker. It apparently wasn’t so difficult at all.
Why Did the Fed Raise Rates?
In its policy statement, the Fed was much more positive about employment, noting that “underutilization of labor resources has diminished appreciably.” The Committee felt the risks facing both the labor market and economic activity were balanced. Further, inflation was expected to rise back to the 2% target as the “transitory effects of declines in energy and import prices dissipate.” The Fed decision was intended to reflect strong confidence in the economy. Even so, Chair Yellen noted that policy would remain extremely accommodative.
So, What's Next?
Now, with rates higher and the Fed showing confidence in the recovery, what will be the future path of rates? Fed Chair Yellen says that depends: at each meeting, the Committee will assess labor market conditions and evaluate actual and expected progress toward its inflation target. The Fed’s projections show falling unemployment, with the rate to 4.7% at yearend 2016, and rising inflation, 1.6% at yearend 2016, and 2.0% at yearend 2018. Thus, the median estimate for fed funds rises to 1.375% at yearend 2016, 2.375% at yearend 2017, and up to 3.5% in the long run. That would imply four rate hikes in 2016 and for the two years beyond.
We doubt rate hikes will be that aggressive. Yes, the U.S. economy seems robust and Eurozone growth may be edging faster. But, U.S. financial conditions have already tightened as the dollar soared and credit spreads widened over the last year. Inflation remains persistently low and growth from abroad stays weak, both factors that could keep the pace of rate hikes slower than the Fed’s dot plot indicates.
Further, few other central banks are raising rates. Most are struggling to ease even further to support weak growth. Brazil and Russia tightened policy, but did so to stop inflation as their currencies collapsed. Monetary policymakers in Hong Kong and Saudi Arabia did push their rates higher in response to the Fed’s move to keep their currencies pegged to the dollar. The Fed is the outlier in central banks.
Will the Fed Regret It's Move?
Opinion diverges widely about the wisdom of the Fed’s move. Some call it a radical mistake to hike rates just as U.S. domestic growth crests and the global economy falls into recession. So, the Fed, like other central banks that hiked prematurely, will have to reverse itself. Others view last summer or even last year as the more appropriate time to have begun to normalize rates and today is just too late. The bond market seems sanguine: yield curves flattened a bit with two-year Treasury yields moving near 1.0%. Reaction of 10-year yields was muted; the demand for long Treasurys stays firm as investors see sizeable risk in the ongoing crash in oil prices. So, the Fed rate hike hasn’t yet set a hugely negative tone for bond markets.
It Depends on Oil:
The widespread market nervousness centers on the renewed oil-price plunge and its negative ramifications for profits, high yield bonds, and the odds of contagion to other parts of the bond market. The loud and vociferous bears see the oil-price plunge due to shrinking demand in a global economy headed for recession. On the other hand, we view the problem as one of excess supply. Oil suppliers, desperately needing revenue, produce all out to cover social expenses and other costs. In this environment, producers will keep pumping oil so long as the price is less than the variable cost of production, a recipe for low prices.
While the odds of any significant rebound in oil prices are slim, we’d view the recent downside breakout as the final capitulation of the collapse that began 18 months ago in June 2014. The implication is that prices may be close to the bottom. Suggestive of that trough is the price action in copper, aluminum, and the Commodity Research Bureau index of raw industrials. All three have been essentially flat since mid-November or so and did not follow the plunge in oil prices. In a similar contrary fashion, while oil prices rebounded in late summer, copper and aluminum prices and the raw industrial index just moved relentlessly lower, refusing to stabilize with oil. We think the rally in the U.S. dollar is mostly over as the huge move this year was in anticipation of fed rate normalization; being long U.S. dollars is a very crowded trade. If the dollar stays flat, commodity prices should stabilize over the next several months and provide somewhat of a respite for beleaguered commodity producers.