WASHINGTON – At last, the US Federal Reserve decided to put an end to the abnormally long period of zero interest rates, or ZIRP. On December 16 Fed Chairman Yellen announced a 1/4 percentage point increase.
More rate increases ahead
In addition, the Fed indicated its intent to continue to “gradually” increase interest rates in 2016 and 2017. In so doing, the Fed signals its intention to bring monetary policy back to “normal”. The emergency mode that goes back to the 2008 recession is officially over.
The argument supporting a rate hike is that the US economy is growing at a steady pace, while unemployment at 5% is back to a physiological level.
Do they really mean it?
However, after reading the modulated Fed statement and after listening to the careful words of Fed Chair Yellen during her press conference, we can also get a very different impression. The Fed did something now. But it is not at all clear that it will carry on with additional rate hikes at a steady pace next year, even though it says it wants to.
In fact, it may very well do nothing next year.
We want inflation
Here is the thing. The Fed declared that additional rate hikes that will bring monetary policies back to “normal” are in large part contingent on the rate of inflation going back to 2%. Right now it is much lower, at 0.4%. Which is to say that if inflation fails to climb to the desired 2% level, the Fed may have to reconsider the pace and the extent of any additional interest rate hikes.
That said, it is quite plain that in a deflationary global economy, with collapsing commodities and energy prices, the chances of higher inflation in the US in 2016 are very slim. Therefore we can conclude that the Fed, while declaring a policy objective, also created an easy way out.
This is what we will do, or may be not
In simple terms, the Fed announcement can be read this way: “Yes, it was about time for all of us in the Federal Open Market Committee, FOMC, to stop this ZIRP insanity. And so we did. We raised rates, even if just a little bit, to prove that we are serious about this. And, of course we would like to raise rates some more in 2016 and 2017. However, we really need inflation at or close to 2% to do this. If this does not happen next year we may have to reconsider any rates hike timetable”.
Got that? Let me say it again, just in case: “We would like to raise rates, but we may not, after all. It all depends on the rate of inflation. If inflation is too low we may pause or raise rates even more slowly than we announced today. Is our intent clear?”
The markets can choose to interpret this statement of intentions this way:
“We have raised rates today. But this is only for show. And we have created a nice way out of additional interest rate hikes. Off the record, we all know that there is no way that inflation will go back to 2% in 2016. And we just told you that low inflation will give us an excuse to dilute or postpone any future action on rates”
Markets are fine with this
Theoretically, any Fed policy move signaling a return to higher interest rates should have spooked the stock market. It is an open secret on Wall Street that stocks are overvalued because ZIRP, the zero per cent interest policy pursued by the Fed for so many years, made stock investing a lot more attractive. Bank deposits and other traditional forms of prudent investment yield nothing.
But the stock market reacted calmly. In fact, right after the Fed announcement, the Dow Jones moved higher.
How so? In my opinion, the markets concluded that the Fed does not intend to seriously tighten any time soon. May be later, but not in the immediate future.
Translation: the Wall Street party goes on.
A different signal would have elicited different market reactions
It would have been a completely different story had Yellen declared that this 0.25% increase is just the opening salvo, the first in a long series of staggered rate hikes that will take place —no matter what. This would have signaled a real policy shift.
Right now there is half a signal. “We would like to, but we are not sure that we will, because low inflation may not allow us to go forward”.
End ZIRP just as the economy peaked
Well, why this muddled message? Very simple. The Fed is in a bind. At some point it had to end this ZIRP anomaly. But the Fed also knows that the US economy, while expanding at a modest 2% annual rate, is not doing so great. Capital expenditures are down. Movement of goods in and out of US ports is down. Major US exporters like Caterpillar are doing poorly because of lack of demand.
A global slow down
Besides, the global economy is very anemic. Europe is not growing much. Japan is in bad shape. China is slowing down. Major commodities exporters, from Brazil to Chile and Australia, are in real trouble. All commodity prices have collapsed. Besides, oil is now at less than $ 40 a barrel, with negative consequences on a large part of the US economy that supports the energy sector.
And finally, all other major central banks, from the European Central Bank to the Bank of Japan, are moving exactly in the opposite direction. While the US begins tightening, they keep on relaxing their own monetary policies, this way devaluing their currencies. Higher rates in America will translate into an even higher US dollar. And this will hurt all US exporters.
This is not a scenario that indicates higher growth ahead for America, therefore providing the rationale to go back to “normal” monetary policies. In fact the global slowdown may even cause a recession in the US in 2016.
Given all this, why did the Fed decide to act now on rates?
A political rate hike
The December 16 rate hike is mostly symbolic. It is about institutional credibility, and therefore mostly about politics, and not about setting a new monetary policy.
The fact is that a Fed rate increase has been openly discussed, anticipated, hinted and almost announced so many times that the FOMC decided that it had to do “something” before the end of 2015. But it did so in a clever way, leaving for itself plenty of wiggle room regarding future moves.
However, because of this deliberate ambiguity, it is hard to read any precise guidance regarding future monetary policies.
Will the stock market bubble continue?
Eternal Wall Street bulls and plenty of speculators will probably conclude that the Fed moved today only for public relations reasons.
Most probably, it will increase rates in 2016 only a little bit, and may be not at all. Therefore investing in vastly overvalued stocks is still relatively safe. The small 0.25% rate hike, by itself, changes nothing.
In other words, to the extent that investors believe that the stock market is alive and well, even after today’s hike and announcements of likely future tightening, we are a long way from getting back to normal.
And this is bad news. At some point, with or without decisive Fed action on rates, the Wall Street party will end. When that happens, speculators and unsuspecting retail investors will be burnt very badly.
A word of advice: Pull out now, before the whole thing collapses.