The Fed stays its hand on US interest rates
22 September 2016 | Markets and Economy
For the sixth time this year, United States Federal Reserve policymakers have chosen to keep unchanged the federal funds target rate – the rate at which US banks charge each other to borrow money, and a key driver of prevailing interest rates.
A rate increase had been looking increasingly likely a month ago based on positive signals from a number of "Fed" officials. Fed Chair Janet Yellen, citing strong US labour market performance and the Fed's outlook for economic activity and inflation, was direct in a 26 August policy speech, saying, "The case for an increase in the federal funds rate has strengthened in recent months." With the labour market near full employment, inflation not far from the Fed's 2% target, and no imminent global economic risks, it seemed just a few weeks back that conditions were set for the Fed to follow through.
And yet the Fed this week left its 0.25%–0.5% rate intact.
"The Fed continues to position itself as data-dependent, so by not following through on raising rates, it may be eroding its credibility," Vanguard Senior Economist Roger Aliaga-Díaz said. "Fed officials appear to be waiting for the perfect moment, domestically and globally, for the next rate increase. We are beginning to question when this might happen."
"Dovish tightening" seems warranted
When it comes to interest rate policy, Vanguard continues to believe that the timing of further hikes is less important than the "terminal" policy rate – the level at which the Fed stops raising rates.
"Although global growth appears set to remain fragile, we see a gradual tightening by the Fed as a prudent and welcome development given the solid macroeconomic fundamentals of the US economy and expectations that inflation will move higher in the medium term," Mr. Aliaga-Díaz said.
During the last tightening cycle, which ended in 2006, the Fed raised its target rate 17 times in two years, to 5.25%. The current cycle is shaping up as much more "dovish", with short-term rates rising at a much slower pace and the terminal rate expected to be far lower than in many previous cycles. In the context of the Fed, "dovish" means the central bank is not inclined to aggressively battle inflation. The opposite stance would be characterized as "hawkish".
In the United Kingdom, "doves" remain ascendant. In August, the Bank of England's Monetary Policy Committee announced a series of measures in response to the deteriorating economic environment triggered by the "Brexit" referendum on 23 June. These included a cut in the BoE's lending rate from 0.5% to 0.25%, the purchase of some £70 billion in government and corporate bonds, and the introduction of a scheme aimed at providing banks with more money to lend to firms and households.
The slow pace of policy normalisation so far has been warranted in part by the long but weak recovery in the US, UK and other countries since the 2008–2009 financial crisis. This sluggishness has persisted despite all the central banks' efforts. Still, US inflation has remained below the 2% target. And since the so-called Great Recession ended, the US economy has been growing at an average of about 2% a year; periods of expansion since the 1950s have often averaged more than 4%.
After so much extraordinary stimulus, Fed officials may want to enact a few rate hikes to counterbalance their previous actions. Markets anticipate the next one in December or the first quarter of 2017. We're likely, however, to see an extended pause after that, allowing the Fed an opportunity to assess the effects of its actions on the economy while maintaining a loose monetary stance.
What would higher rates mean for bonds?
Fed rate increases could well bring some short-term pain to fixed income markets.
"Changes in monetary policy are often accompanied by market volatility, and bond prices fall as interest rates rise," said Mr Aliaga-Díaz. "That said, a slow and steady path of higher rates could help mitigate volatility risk by removing some of the uncertainty about when the Fed will act."
But as he noted, rising rates are actually good for long-term investors. Earned income being reinvested at higher rates will not only help to offset bond price declines, but they can also compound over time into a significant portion of the total return of an investor's bond allocation.
And keep in mind why investors turn to bonds in the first place. Bonds can play an important role as a diversifier for equities and other riskier assets. This remains true even if bond returns may not be as strong in future as what investors grew accustomed to over the past several decades.
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