The path of interest rate normalization has proven anything but normal.
Back in December, the Federal Reserve raised interest rates for the first time in nine years, strengthening hopes that the economic recovery was firmly on track and the central bank could begin unwinding years of extraordinary monetary policy. Growth was running at a rate just shy of 2.5 percent, the economy was creating nearly 230,000 jobs a month and Fed members confidently predicted the central bank would raise rates four times in 2016, providing clear distance from zero.
Today, as the Federal Open Market Committee prepares to conclude its latest meeting, financial markets assign virtually a zero percent probability that Chair Janet Yellen and her colleagues will raise rates, and predict only one or at most two hikes for the remainder of the year. What’s going on here?
Recent economic data has been mixed. Payroll employment growth has declined to less than 150,000 a month this year, including a dismal 38,000 in May, productivity growth has slowed to a crawl and investment remains sluggish. Yet wages are growing at a 2.5 percent clip, retail sales have picked up. Inflation is nudging closer to the Fed’s 2 percent target and economic growth appears to have recovered from the first-quarter slowdown, with many forecasters predicting growth at a 2.5 to 3 percent pace in the second quarter.
Financial markets are flashing warning signals, though. Far from rising in anticipation of further increases in policy rates, long-term U.S. rates have fallen to near record lows. The yield on the 10-year U.S. Treasury, which stood at 2.30 percent at the time of the December hike, has fallen to just 1.63 percent. The spread between the two-year and 10-year yield has dipped below 90 basis points, a clear recession warning signal for many investors.
“I’ve never known a more precarious time,” says Michael Power, strategist at Investec Asset Management, the London-based money manager. Global growth remains tepid, Abenomics is losing traction in Japan and rates are going further into the negative rabbit hole in Europe. With the yield on 10-year German bonds falling below zero this week, fully 40 percent of the world’s sovereign bonds now sport negative yields.
All of which leaves the Fed facing a Catch 22 situation. Policymakers desperately want to normalize rates to give themselves more leeway to counter a future downturn, but such actions risk precipitating just such a downturn. Asked if the Fed should raise rates, Power says, “I think they should, but they might end up strangling the [business] cycle in its bed.” The strategist expects a U.S. recession to occur “almost definitely within 12 to 18 months.”
Wilbur Ross Jr., chairman of the $11.9 billion distressed debt investment firm WL Ross & Co., argues that the Fed’s own dithering is contributing to the malaise. He wants Yellen to raise rates by another quarter point in June. His view seems to be shared by a number of regional Fed presidents, including John Williams of San Francisco and James Bullard of St. Louis.
“I think their public hand-wringing over whether to go up 25 basis points has made it a much more dramatic event for markets than it deserves to be,” he says. “Think about it. If all that matters for the U.S. economy is 25 basis points, we’ve got nothing going for us to begin with. So I think they should’ve been more decisive and more clear about their direction because business can deal with low rates, business can deal with high rates. Hard to deal with uncertainty. Uncertainty paralyzes decision-making.”
Uncertainty about Fed policy is frustrating. But the past six months have shown that the Fed, and the U.S. economy, are at least as much hostage to global forces as they are drivers of the world economy. The Fed may have missed an opportunity to start the tightening cycle earlier in 2015 when the economy was accelerating, but it’s hard to see how a rate hike today will instill confidence.
Where does that leave Yellen? I expect the chair to portray a relatively upbeat picture of the U.S. economy at her post-meeting news conference and to keep alive the prospect of rate hikes in the near future — July anyone? September? But don’t expect the Fed’s updated dot plot of future rate levels to have much bearing on reality.
“One senses they really want to raise rates and achieve a more ‘normal’ stance,” former Treasury secretary Larry Summers wrote in the Washington Post this week. “But at the same time they do not want to tighten when the economy may be slowing or create financial turmoil. So they keep holding out the prospect of rate increases and then find themselves unable to deliver.”
Maybe the new normal is no normal at all.
Follow Tom Buerkle on Twitter at @tombuerkle.
