Fed Will Hike, But Will It Matter?

6/15/2015


Imagine you're Fed Chairwoman Janet Yellen, and you must determine whether to raise interest rates. Here's an economic Rorschach to help you make the call:

• GDP fell 0.7% annualized in the first quarter. While that number could be revised upward at the next reporting period, GDP growth was anemic by any reasonable standard. 

• Labor productivity declined 3.1% in the first quarter, the second consecutive quarterly decline. Only three times in the last 25 years has productivity fallen in two straight quarters.

• West Texas Intermediate crude-oil prices have rebounded 38% from their March low but remain 44% below their June 2014 high. Falling oil prices didn't fuel consumer spending nearly as much as many pundits anticipated, and the recent rise certainly won't cause consumers to open their purse strings.

• The dollar's strength — the U.S. greenback has gained 19% versus the euro over the last 12 months and 18% against a basket of six major currencies — presents challenges for a host of U.S. companies, especially those with large overseas exposure.

• The Dow Jones Transportation Average — a very economically sensitive index — just closed near a seven-month low.

• The economic picture overseas, though improving in parts of the world, is hardly robust. The eurozone is growing at a sub-2% rate. And growth in some emerging markets, such as Brazil, is nonexistent. This keeps pressure on the U.S. to continue pulling the global economic wagon.

Is this an environment for raising rates?

Reasons to hike

Interest-rate hawks counter that underlying economic growth is stronger than recent numbers indicate. Many economists still see 2%-plus growth this year despite the rocky first quarter, with a solid pickup in the second half. Rough winter weather, a West Coast port strike, and a strong dollar, not to mention the government's methodology for calculating GDP growth (which appears to have some seasonal glitches) overstate the economy's underperformance.

People are buying cars (auto sales reached a 10-year high in May) and homes (home sales for 2015 are expected to be the highest since 2006). The labor force is growing — employers added 280,000 jobs in May, well above the monthly average of 255,000 over the last year. And average hourly pay rose 2.3% in May, the biggest jump in nearly two years. This year's bump-up in yields — the 10-year Treasury's yield rose this month to its highest level since October — is the bond market telling us the economy is rolling faster than data indicate. Finally, the Fed perhaps may be starting to worry that its zero-interest-rate policy is creating bubbles in a variety of asset classes, with the private and public equity markets most often cited.

All of which gives the Fed plenty of cover to raise rates. And the Fed will likely raise the fed funds rate this year, probably in the fall.

But it shouldn't matter much to the economy or the stock market. Here's why:

To call this rate hike telegraphed would be an understatement. A boost this year shouldn't surprise anyone. Said differently, the stock market has already discounted the Fed raising rates in 2015.

Most pundits expect measured and probably modest rate hikes, and the first one shouldn't have any immediate impact on credit demand.

The first rate hike shouldn't scare investors. It's the second, third, and fourth increases that cause problems. For now, with inflation tame and many uncertainties surrounding the economy, we don't see the Fed going on a rate-hiking binge.

Bottom line: In our view, the Fed remains a long way off from "early-and-often" tightening. Of course, the stock market could still misbehave over the next several months — for example, if the economy's swoon continues, taking down corporate profits and stock prices. Or if intermediate- and long-term bond yields rise for reasons other than a strengthening economy, such as a rekindling of inflation. But if the market and economy tank, it won't be because the Fed raises rates in the fall.


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