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Will There Be A Long Term Impact To The Fed’s Shift In Rhetoric?


  • A positive outlook seems more political than realistic as the FED is out of maneuvering power.
  • Keeping interest rates unchanged is the best and the only thing the FED can currently do.
  • Low interest rates will weaken the dollar, boost exports and increase corporate earnings in the upcoming earnings season.

Introduction

In FED’s Chairwoman Yellen semiannual policy report, the rhetoric has significantly changed since the last report in February. In short, the full employment target is almost reached but the inflation rate is still below the targeted 2% and the expectations for the reaching of that target have been changed from short term to medium term. Further, the latest job reports show a slowdown in jobs increases which creates a bit of a scare. The FED estimates the slowdown to be transitory.

On the positive side, wages seem to be finally picking up which is a good sign for inflation. Weak data comes from the economy where the U.S. GDP grew only 0.75% in Q1 2016 on an annual basis due to the fact that the expensive dollar weighs on exports, low oil prices and weak business investments.

The FED On The Economy

On one side, Yellen says that the slowdown in employment should be only transitory and that data from one quarter does not mean much, while on the other side she states that the quarterly pickup in consumer spending and increase in household wealth will bringfurther improvements in the labor market and the economy more broadly over the next few years.

As always, in order to show the other side of the medal Yellen mentions risks like lower employment and business investments that might lower domestic demand, the general slowdown in U.S. productivity potentially continuing, a stronger slowdown in China and a possible Brexit. All of the mentioned possible scenarios might have a negative impact on investors’ perception of risk and therefore abruptly change the current stable market situation.

Monetary Policy

The FED decided to keep interest rates unchanged and even more importantly, keep the FED’s holdings of longer-term securities at an elevated level.

The most important part of the report is related to the fact that interest rates are expected to increase only gradually as the economy is too weak to withstand sharper increases. The necessary rate needed to keep the economy operating close to its full potential is low by historical standards. Only if the above mentioned uncertainties and productivity, and employment slowdowns fade will the FED increase interest rates gradually, if not, rates will remain like this for a longer period of time.

The report is concluded with the case that if the economy were to disappoint, the FED would lower its interest rates.

Comment

In relation to the potential lowering of the interest rate in adverse economic situations one might ask:

Lower the interest rate to where?

As the interest rate is at historical lows, a lowering from 0.5% to 0% doesn’t seem at all significant. It is highly unlikely that demand for houses in a recession will increase if the mortgage rate decreases from 3.75% to 3.25%. In order to be significant for the economy, interest rates have to really have an influence on demand as they had in the previous monetary interventions.

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Figure 1: FED interest rate changes. Source: Trading Economics.

Probably everyone expected that the economy would pick up like it did in the 1990s and 2000s, but it hasn’t in the last several years, at least not enough to ignite inflation or allow interest rate increases. This puts the FED in a difficult position as it has no maneuvering space if any economy shocks happen. The good news in the bad news is that a similar situation is affecting Europe, Japan and China, so the FED can keep interest rates low without severe outflows of capital.

Long Term Outlook

Keeping the interest rates unchanged is probably the only thing the FED can do at this moment as there are no clear indications in where the economy is going. The current home sales are at a nine-year high, but this again does not change the structural problems like the low productivity because with a sold home no value is created, only on paper due to the increased asset prices further fuel the asset bubble. The median house price increased by an astonishing 4.7% compared to last year.

The low interest rates will weaken the dollar in relation to other currencies and thus make U.S. exports more attractive. Also, corporate earnings will be higher when translated to dollars which should have a good impact in the upcoming earnings season.

figure 2 dollar
Figure 2: Dollar index has been falling in the last 6 months. Source: Bloomberg.

But, the structural issues are still lingering behind the good news and sooner or later, hopefully later, will have an impact.

The FED will continue in trying to keep things stable which is remarkable, and no one can know how long the FED will succeed in this. Perhaps even for years as it has already been doing this for more than 7 years.

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