Fed Will Bark Before It Bites
Markets aren’t ready for the Federal Reserve to tighten policy, but it may be trying to change that
Investors on Wednesday will be carefully parsing the statement the Fed releases following its two-day meeting and Chairwoman Janet Yellen’s postmeeting news conference for any hints on when the central bank might start raising rates. This is something economists are sharply divided over, with nearly half the respondents to The Wall Street Journal’s latest forecasting poll looking for a “liftoff” in the second quarter (read: at the June meeting), and the remainder expecting it to come in the third quarter or later.
Whenever the Fed starts tightening, the trajectory of rates likely won’t be steep. Rather, with inflation still below its 2% target, rate increases will be incremental, with the central bank pausing if the economy seems to soften. That is because the aim isn’t to cool an overheating economy, but to put into motion a yearslong process of getting overnight rates from near zero to the 3.75% that the Fed sees as normal.
Yet investors have been unusually sensitive to changing views of when liftoff will likely occur.
The strong February employment report, which strengthened the case for a June rate increase, sent stocks down sharply. Last week’s weak retail sales report, which pushed the needle toward the Fed’s September meeting, saw stocks rise.
The problem might be investors put little faith in the Fed’s ability to hold back on ratcheting up rates once started. But given low inflation, another culprit seems more likely: valuations.
Similarly, long-term Treasury yields are far lower than they were a year ago. The term premium on the 10-year note, or the extra compensation investors demand to hold it over cash, has fallen sharply this year into negative territory, bringing it to some of its lowest levels in over 50 years.
Such high prices make markets more sensitive to little things going wrong, like the Fed tightening sooner than investors are prepared for. And they seem unprepared.
The shadow funds rate ended February at minus-1.97%. This is a measure maintained by the Federal Reserve Bank of Atlanta based on where yields on Treasurys suggest overnight rates would be, if they could go below zero. That leaves it with a wide gap to fill by the time the Fed raises rates. And filling that could take substantial movement in Treasury yields.
The situation presents the Fed with a problem: It doesn’t want its first rate move to cause a severe market reaction that puts the economy at risk. Yet it doesn’t want to delay acting just because that might knock pricey assets lower. Optimally, it would like investors to gradually steel themselves for the first increase so that when it does actually come it doesn’t cause problems.
One way to accomplish this might be to keep the possibility of a June tightening open as long as possible, pushing markets to start adjusting, only to pivot to a later increase. If the Fed sounds hawkish after its meeting this week, bear this in mind.
A small rise in interest rates by the Federal Reserve should have little effect on the economy.