An interest rate hike by the Federal Reserve is on the mind of just about everyone working in financial services (and consumers as well). People want to know when, how much and how many.
Based on what the majority Fed governors and Federal Open Market Committee members have said publicly, a rate hike is coming. The real question is, when.
I contend that the Fed will most likely raise rates by .25% in December. Before we dive in, let's take a look at what motivates the Fed to raise rates — using the backdrop of the dual mandate (full employment/price stability) and high level economic trends and characteristics.
The Motivation to Raise Rates
With an anemic Gross Domestic Product (relative to past recoveries) averaging under 2% during the "recovery," there is little chance of rapid expansion that would typically trigger the type of inflation concerns usually needed to support a rate hike.
In fact, the past five years have seen inflation stress points caused only by supply (manufacturer decisions) not demand, which is why there has been so little pressure on inflation. Why is GDP so weak in this "recovery"? In part, it is because of the low labor participation rate we have had during this "recovery."
The participation rate currently ranges between 62.5% and 63% compared to a historical range of 66% to 67%. It can be argued this is due to baby boomers retiring, or a skill mismatch between job openings and workers, or people simply choosing not to work. The reason is not as important as the impact: With fewer people working, the workforce has less economic potential — making it much harder to produce GDP levels needed to spur inflation and subsequently support a rate hike. We all know raising rates when GDP and inflationary conditions don't support doing so can stall a recovery, or worse, trigger a recession or even deflation.
All that being said, even at .50% (the top of the Fed's target range) Fed Funds is incredibly accommodative. They could move the top rate to .75% or even 1.00% and still be accommodative. The very fact that the Fed hesitates so frequently to raise rates, is an indication of just how fragile the Fed fears the economy may be. Even so, the argument to raise rates is a strong one. It would provide the Fed operating room for the next economic slowdown. With a target range of .25% to .50%, the Fed has little room left to stimulate growth in the event of a recession. They need this maneuvering room, and don't forget even a .25% increase would still leave Fed Funds very accommodative. At the same time, the Fed remains concerned about real estate values having witnessed the devastating impact falling real estate values can have on the rest of the economy.
Answering the Three Questions: When, How Much and How Many?
We started off with three questions: When, how much and how many. The Fed will most likely raise rates in December. Why? Because it worked last time. The holidays drew enough attention away from Fed decisions that the interest rate hike did not result in much of a negative outcome and nothing lasting occurred. The Fed loves routine and likes to use what it considers to be a proven technique; I think they will count on the Holiday distraction factor again.
They will raise rates .25% because:
- They want to take small steps
- .25% worked last time
There will be two total rate increases in the next 12 months. One this year (December) and one prior to July 2017. That will take the top of the range to 1.00% — giving the Fed the operating room they seek.
That being said, the Fed's efforts will focus only on the short-end of the yield curve — they will maintain balances accumulated during quantitative easing in an attempt to keep the long-end of the yield curve stable. In other words, the yield curve will flatten on the short-end. If the Fed truly wanted to raise rates, they would allow their balance sheet to amortize off (making it more possible for the entire curve to shift up). Their goal is to create room to cut rates for a recession (if one occurs), while at the same time maintaining real estate values (in as much as they can influence).
This scenario has the potential to put further strain on credit union and bank net interest margins. When the Fed raised the rate last time, there was very little market impact on loan or deposit rates. However, with each successive increase, pressure will build to increase deposit rates during a time when the market has come to expect rock-bottom loan rates. In contrast, most institutions will be loath to increase deposit rates unless they can also increase loan rates. Overall, an interesting dynamic to watch play out.
Earlier, I said a low labor participation was part of the reason GDP was so weak. Other reasons include:
- The Fed only has control over monetary policy — which has limits — and is generally most effective within the confines of fiscal and other government policies that impact the economy.
- It can be argued the Fed is as effective as it can be given current fiscal and other government policies. Until such time more pro-growth fiscal and other governmental policies are implemented, there is little more the Fed can do to improve the economy, or stabilize it, should there be a slow-down.
One final note on real estate values. Interest rates are a significant factor in how home prices are determined. The lower the rate, the lower the payment and the more affordable a home is all-other-things being equal. This low-rate phenomenon is what has helped housing prices recover and maintain value since the crisis of 2007-2008. And, this is why the Fed prefers to keep long-term rates low, while trying to raise short term rates.
Todd Harris is the CEO of Tech CU, a $2 billion credit union serving more than 75,000 members throughout the San Francisco Bay Area.
