Last week the market reacted positively to the Fed’s statement, in which the word “patient” was removed. This sets the stage for possible rate hikes as early as the June meeting. But the Yellen Fed artfully orchestrated a give-and-take approach, convincing the markets that while they need the flexibility to raise rates when appropriate, that won’t happen until the economy can handle it, and the path of rates increases will be more shallow than previously anticipated.
The Fed uses what’s called a “Dot Plot” to depict individual Fed members’ forecasts for the Federal Funds rate over the next few years, as well as for the longer-run equilibrium. As Benjamin pointed out on Thursday, the median rate outlooks were reduced substantially for 2015 and 2016.
This is what the current Dot Plot looks like (from Business Insider). Don’t spend too much time studying it, as it changes all the time.
If you recall this previous article, an argument can be made that the Federal Reserve has killed all economic expansions over the past 50 years. They have done this by aggressively hiking rates in order to slow down an overheating economy.
One of the key takeaways, looking back, is that when rates move too far, too fast, it can have a devastating impact on the economy, often throwing it into recession.
[Listen to: Matthew Kerkhoff: Still No Sign of Recession or Bear Market]
Many market participants are not overly worried about rising rates, but they are worried about rates rising too quickly or to an unwarranted extent. The Fed has been going to great lengths to communicate to markets that this will not be the case … the latest reduction in Dot Plot forecasts is the most recent example.
Federal Reserve Vice Chairman Stanley Fischer spoke to the Economic Club of New York yesterday afternoon and made a couple of interesting comments. Recall that Fischer retains a somewhat elevated position among Fed members as a result of his academic relationships with a number of prominent leaders. As a professor of economics at M.I.T., Fischer’s list of former students includes former Fed Chairman Ben Bernanke, ECB President Mario Draghi, and IMF Chief Economist Olivier Blanchard, among others. Fischer also led Israel’s central bank for eight years.
Two comments caught my attention from his talk yesterday. The first one had to do with the path of rate increases. He stated that a smooth upward path in rates “will almost certainly not be realized because, inevitably, the economy will encounter shocks.” This is important because many feel, and history suggests, that once rates begin moving up, they do so steadily until the pendulum swings too far and serious economic repercussions are inevitable.
[Hear Also: Jim Puplava’s Big Picture: Yellen Is Tellin: It Is Going to Be a Slow Slog]
The takeaway for me is that this Fed is more cognizant of past mistakes and seems to have a better understanding of the lead time required for monetary policy to take effect. When rates begin to rise, it does not mean we will be on a sustained upward path of monetary tightening. As Fischer says, the path may be volatile and may include rate cuts along the way, as developments arise and economic data supports alternate considerations. The strong dollar was used as an example that could offset monetary policy decision making.
The chart below shows the U.S. Dollar Index over the past ten years. You can see that we recently crossed the 100 threshold, a value not seen since the early 2000’s. This is throwing a wrench into the Fed’s plans, acting as its own form of monetary tightening. Yet at the same time it may be the saving grace for our economic partners. On Wednesday we’re going to talk more about QE, which the ECB just embarked on, and whether the real benefit may come not from the explosion of liquidity or suppression of yields, but via currency moves.
Fischer’s second comment, that I found rather entertaining, was in reference to the initial one or two rate hikes. He said, “We will be moving from an ultra-expansionary monetary policy to an extremely-expansionary monetary policy.” The crowd liked this, as did I. Point taken Mr. Fischer; a minor and relatively inconsequential move in rates is unlikely to “release the Kraken.” Just because rates may go up by a quarter or half point, it does not mean we will be leaving this period of accommodative policy.
For the past year we’ve been anticipating rates finally leaving the zero bound. Historically, the early phases of rate hike cycles are beneficial for stocks, but they do come with volatility. This next cycle of rising rates will be unique in that we’ve never risen from zero, but we should expect the Fed to remain relatively accommodative and take things slowly. If done in an orderly fashion, the financial markets and the economy should have time to assess the impacts and react appropriately.
The following was an excerpt of Richard Russell's Dow Theory Letters. To receive their daily updates and research, click here to subscribe.
