The Interest Rate Guessing Game By Lewis J. Walker, CFP(R)

In December the U.S. Federal Reserve Bank raised the federal funds interest rate by one-quarter of one percent (+25 basis points) to 0.50%, after years of easy money rates approaching zero. What does this mean to you?

Edgar R. Fiedler (1929-2003), economist and former Assistant to the Secretary of the Treasury, observed that in probing an economic conundrum you are likely to be confused more than enlightened. “Ask five economists and you’ll get five different explanations...six if one went to Harvard.”

Despite the hazards of pythonic ponderings, whether you are a saver, borrower, accumulating investments, or shifting from saving to distributions in retirement, the direction of interest rates is important to financial, investment, and asset allocation strategies. The “fed funds rate” is the interest rate at which a bank lends funds maintained at the Federal Reserve Bank overnight to another bank. It is set by the Federal Open Markets Committee (FOMC), the Fed’s primary monetary policymaking body. The fed funds rate influences other interest rates with broad implications for the economy. The hike with hints of more to come this year reflects the desire of Federal Reserve governors to move toward “normalization,” letting interest rates rise based on economic conditions, transitioning away from a manipulated rate environment.

While you may hear hysterical cries about “rising interest rates,” usually in concert with a commercial trying to sell you something, note that while the Fed controls the overnight bank lending rate, it does not control yields on benchmark 10-year or 30-year Treasury bonds. The yield along the longer end of the yield curve may or may not rise simply because the Fed increased overnight rates. In fact, the day after the well-anticipated fed funds rate hike, yields on one month Treasury bills to 10-year notes fell as demand from investors drove up prices. (Yields and prices move in opposite directions).

Of course, longer term rates could rise. A commentary from the fixed income specialists at Belle Haven Investments in Rye Brook, NY, noted that from May 2004 to May 2006 the fed funds rate jumped from 1% to 5.25% (+425 basis points). Over that time frame the yield on 10-year notes rose only 50 basis points, while the yield on 30-year paper declined by 19 basis points!

No one expects the fed funds rate to rise rapidly given myriad constraints. Speculation asserts quarter point increases in four increments this year, but even a rate of 1.50% is way below historical norms. Most likely, relatively cheap money for the foreseeable future!

The big jump in the fed funds rate 2004-2006 was based on doubts that the Fed could keep inflation under control. The real driver of interest rates is inflation. In times past, the Fed “took away the punchbowl” when inflation was rising rapidly along with increased speculation and overheating markets. The Fed’s challenge today is low inflation below the stated target of 2% annually, exacerbated by falling energy and commodity prices.

The Fed walks a tightrope. Eyeing the commodity bust, soft global growth, rising debt burdens, strains in high yield bond markets, plus pressure from a strong dollar, the Fed will monitor U.S. economic statistics for signs of domestic job and GDP growth before increasing rates much further. The last thing Fed-head Janet Yellen wants to do is to tip the economy into recession.

With foreign central banks pushing quantitative easing and easy money, the dollar attractive to global investors, especially as a safe haven in tumultuous times, American interest rates will be constrained. Savers will see tiny increases in money market yields and you are being urged to spend your “cheap oil dividend” to boost the economy. Kiplinger forecasts U.S. GDP growth at 2.8%, up slightly from 2.5% in 2015, along with modest wage rate increases and improved consumer spending.

The Fed had to act because virtually zero interest rates were increasing risk taking and pressures were rising for normalization. Failure to act would have signaled the Fed did not believe the economy was strong enough to withstand a puny rate increase. If Fed “sugar daddies” didn’t have faith in the strength of our economy, you would not want to see that reaction!

In 1939, in preparation for World War II, the British government created a motivational poster that urged, “Keep calm and carry on.” That slogan lately has reappeared on T-shirts sold in London. Good advice for 2016.

Happy New Year! Carry on!

Lewis Walker is President of Walker Capital Management, LLC. Securities and advisory services offered through The Strategic Financial Alliance, Inc. (SFA). Lewis Walker is a registered representative and investment adviser representative of SFA which is otherwise unaffiliated with Walker Capital Management, LLC.

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