- The Federal Reserve continues to hold to its mantra that it will keep U.S. interest rates low for an "extended period of time." However, that message seems to be meeting deaf ears. U.S. corporate...
Economic Research: It's Only Up From Here
The Federal Reserve continues to hold to its mantra that it will keep U.S. interest rates low for an "extended period of time." However, that message seems to be meeting deaf ears. U.S. corporations are racing ahead of what everyone knows is coming eventually: the day when the Fed will start to tighten monetary policy after nearly four years (and counting) of easy money.
Corporate America's expectations aren't unfounded. With interest rates at historic lows, the U.S. economy continuing to grow, and rising fears that inflation is lurking around the bend, it doesn't take an expert to conclude that U.S. interest rates have only one way to go: up. The questions, then, are how fast and how much? Will the upcoming moves derail the recovery and who will feel the most pain?
However and whenever the Fed acts, we don't expect its moves to derail the recovery. Although the recent shock of oil reaching $100 per barrel and the supply shock from the Japanese crisis are having a much bigger effect on economic growth, the U.S. Economic recovery still looks to be in place. Household and corporate balance sheets have improved since the financial crisis (partly at the expense of the public-sector balance sheet). Personal savings rates have increased, and corporate profit margins have widened to record highs. With private demand finally picking up, businesses have started to hire again--though only enough to keep the pace of recovery at half-speed.
With the unemployment rate stubbornly above full employment levels and the current soft patch pointing to another modest GDP figure for second-quarter 2011, the Fed will likely tread carefully with its interest-rate moves, giving the economy more time to heal. At Standard & Poor's, we expect the Fed to only start increasing interest rates by early 2012 and to continue to do so through 2014 until they reach 4.0% by year-end. Higher rates will increase borrowing costs in the U.S. and slow down growth, since the better returns from higher interest rates for cash-rich investors would only partially offset the slow down.
Some groups will be at risk once the Fed takes the air out of the economy's sails. The still-fragile housing sector will likely be the first to feel the effects of higher interest rates. Debt-poor consumers will cut back on spending as they attempt to cover their higher debt charges. Businesses that are losing revenue will reduce hiring, which will further slow down growth.
The baseline forecast is for a gradual increase in interest rates. But there are risks to this outlook. Even if the Fed raises rates in baby steps, long-term rates could climb more quickly than expected over worries that inflation will climb higher or that the government cannot manage its massive debt.
As Low As We Can Go
Any increases will be relative, of course. Over the past few years, the Fed has lowered the federal-funds rate to nearly zero--the lowest it can go--in hopes of spurring lending. Even that wasn't enough to stimulate consumer spending and raise employment rate. So the Fed followed with an alphabet soup of measures aimed at boosting liquidity in the economy, plus new insurance programs, which aimed to help calm investor fears. These strategies helped spur private demand that had all but dried up. By the spring of 2009, the financial markets had started to heal.
In the process of engineering a steady, although painfully slow U.S. recovery, the Fed flooded markets with liquidity, and created a $2.86 billion balance sheet that needs to be unwound at some point. Everyone is wondering when the Fed will initiate its exit from easy money, how fast the withdrawal pace will be, and what the effect on growth might be.
Although a few members of the Federal Open Market Committee (FOMC) had expressed concern over the current loose monetary policy, the recent economic slowdown kept the Fed on the side-lines at the FOMC meeting in June, and the Fed continues to hold back on tightening, keeping the federal funds rate between 0% and 0.25%. The discount rate is set at 0.75% and is below the historical spread from the federal funds rate.
In fact, no one dissented from that position at the June FOMC meeting. The Fed continues to label inflation in the economy as transitory and unemployment as elevated. At the post-meeting news conference, Fed Chairman Ben Bernanke, while not calling inflation a long-term concern of the Fed, did call it distressing for consumers.
The upshot is that the Fed does seem to be thinking about when to begin raising rates. Its recent decision to stop buying long-term Treasury debt, while reinvesting as the notes mature to keep its portfolio level, signalled a revisiting of its easy policy at the next meeting. However, Mr Bernanke's statement on June 22 that the Fed doesn't "have a precise read on why this slower pace of growth is persisting," sounds like the Fed's "transitory" mantra is running thin. The Fed expects the economy to settle into a disappointing recovery and seems to believe that it has done all that it can do, for now. Mr Bernanke reiterated that no new quantitative easing program, or QE3, is in the works.
At the April FOMC meeting, members extensively discussed their stimulus plan exit strategy, according to the meeting minutes. There has been some internal debate at the Fed about raising the discount rate to 1.25% to maintain the traditional one percentage point spread over the Fed funds rate. If that happens, consumers would likely be lightly affected because the prime rate would probably remain at 3.25%. But it would be viewed as a precursor to a Fed-rate increase.
We expect that the Fed will move slowly in tightening policy rates for several reasons. Unemployment rates are high, and wages are sluggish. With industrial companies still operating at low capacity rates, growth will likely remain slow through next year, with inflation (excluding energy and food) staying soft.
When the Fed eventually raises nominal interest rates, the increases will likely lag behind the increase in inflation. In short, monetary and fiscal conditions, like the rest of the world, will continue to be easy and should make the recovery resilient for now.
Why So Slow?
Some observers think policy should soon shift from easing to tightening to ward off inflation. But with the U.S. economy hitting a few bumps along the road to recovery, we expect that the Fed won't overact. GDP grew a tepid 1.9% in first-quarter 2011. In our opinion, that means low interest rates are still needed to spur growth.
