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Precise Imprecision

Market Thoughts 12.16.2015

The U.S. Federal Reserve raised its key interest rate target by .25% today, moving from a range of 0 to .25% to .25% to .50%. Before today’s decision, interest rates had remained at “emergency” levels since late 2008 when the Fed cut its target rate to an all-time low during the financial crisis. While we do not want to add to the chorus already pontificating on today’s events, we would like to put some context around the Fed’s decision and discuss some of its potential implications.

One could observe today’s Federal Reserve decision as following a precise chronological sequence. The Federal Reserve system was born exactly 102 years ago (December 1913), the Federal Reserve cut interest rates to their lowest level ever exactly seven years ago (December 2008), and now December 2015 also has its own significance in capital market history.

As Fed Chair Janet Yellen highlighted during today’s press conference, being a central banker is a less-than-precise occupation. On paper, the Fed’s mandate appears simple: help the economy create jobs, keep prices in check, and seek stable interest rates. In practice, the economy’s complexity, consumer behavior, interplay between global markets, corporate spending, political events, and other considerations make the Fed’s task daunting. 

The Fed has a limited number of tools at its disposal. Interest rates are one of them (low interest rates keep borrowing costs down and encourage spending). With interest rates at suppressed levels, the Fed would have even fewer resources to combat a weakening economy should one develop. Forecasting economic changes and the variables that drive them is an inexact science, and today’s decision gives the Fed some flexibility to address the global and U.S. economies’ future paths 

Mixed Economic Landscape

During the financial crisis, all countries experienced credit market seizures, impaired financial institutions, and growing unemployment. Central banks played an essential role in the global economy’s recovery, and the Federal Reserve is credited with being the leader in policy swiftness and depth. 

As we have conveyed in the past, countries emerged from the financial crisis at varied speeds. These uneven growth trajectories have left economies in very different places. Some regions have seen growth rebound with vigor (India). Others have experienced steady-but-unspectacular growth (the U.S. and UK). A few remain more subdued than policy makers desire (Europe, China, and Japan). 

The Fed’s continued importance, coupled with its leadership as the first major central bank to raise interest rates in the last few years (Europe tried to raise but reversed course), left some concerned about how the rest of world’s economic progress would impact the Fed’s decision, and how the Fed’s decision may impact the rest of the world. While today’s response is less than a full trading day’s reaction, Chair Yellen is likely pleased that the well-telegraphed decision met with muted responses in the bond and currency markets, and global stocks performed well.

Today’s Significance

Beyond its historical significance, today’s decision may serve as a vote of confidence for markets. According to Chair Yellen, the Fed took action because the U.S. economy is on a sustainable path. Unemployment should continue to fall, and inflation will likely increase to levels consistent with healthy growth. She also cited that, while they are not growing at robust levels, international economies have also improved.

To be sure, some market observers do not feel the U.S. economy is strong enough for higher interest rates. They point to weak manufacturing, the strong dollar, and recent commodity price drops that have disrupted several growth industries (rather than providing the expected tailwind). Also, many fear that the Fed may raise interest rates faster than capital markets expect, which could cause riskier asset classes to fall. This last issue remains somewhat unresolved after today’s meeting despite Chair Yellen's statement that the Fed will remain accommodative. We will be watching this in coming months.

Consumers may wonder if today’s move will increase borrowing costs. While some banks immediately responded by increasing their prime borrowing rates, these increases are likely to be small, and rates remain very low. Optimists point out that banks may start to pay more on deposits, but banks increase deposit rates on a lag, so, when they come, increases will likely be inconsequential.

Finally, to put today’s rate increase into proper context, we need to look back at where rates have been over the past few years. As you can see from the graph below, today’s interest rate increase barely registers.

Our expectation, as it has been for years, is that interest rates will remain low, and the Fed will move at a gradual, dare I say imprecise, pace. Today’s decision does not impact our investment outlook in a meaningful way. We expect a low-return environment to persist, but we continue to see several pockets of opportunity in the global capital markets. Depending on how markets react in the coming weeks, more could emerge.

If you have questions about how today’s decision may impact you, please do not hesitate to let us know.

Onward,

Eric J. Freedman
Chief Investment Officer