After several years of expected rate increases which failed to materialize or stuttering half-steps, the Federal Reserve looks like it is finally meeting market expectations for rate increases. The Federal Reserve bumped rates another quarter point Wednesday – a move widely anticipated by traders. There was one dissenting voting member -Minneapolis Federal Reserve Bank President Neel Kashkari – who preferred reductions in the Fed’s balance sheet (i.e. selling off bonds which the Fed purchased during its quantitative easing programs) before committing to increased rates. Still, this is an important step. It’s only the third interest rate increase in the past decade, and the language from the official release suggests more increases in 2017 – the widely expected target is 3 rate bumps this year.
Why? What’s changed this time? The economy has been, by most fundamental metrics, healthy and improving for years. Why is there more confidence in the increased pace of interest rate hikes despite the lack of difference of fundamental characteristics? It turns out there is a bullish case and a bearish case for rate increases right now.
Let’s consider the equity markets for a moment. Janet Yellen, head of the Federal Reserve, had a few telling comments about the boost in the market since the election of Donald Trump. As we have noted before, there have been few fundamental changes in the underlying data, but the markets seems to be rewarding Donald Trump’s ascent with improved investor sentiment. Chairman Yellen’s argument is, “I think market participants likely are anticipating shifts in fiscal policy that will stimulate growth and perhaps raise earnings.” In other words, investors expect positive changes to our growth rate. If you believe Trump, than being optimistic makes sense - Trump has been nothing but bullish on his ability to encourage growth.
For clarity, the Federal Reserve does not have to give one whit about market action. Despite analyst accusations (like the so-called “Greenspan put”), the Fed’s job is not to keep markets high. Its dual-mandate is to promote price stability and promote healthy employment levels, in that order. However, an exuberant stock market is usually correlated with high growth, which in turn leads to price inflation. So, the bullish case for rate increases is that Donald Trump’s pro-growth policies take effect quickly, and inflation - already primed for danger given the minimal slack in labor market and excess un-invested cash at personal and corporate levels – quickly gets out of control. So, keeping a lid on inflation with pro-active rate increases is wise. That’s the good scenario.
There is a bad scenario as well. Here is the bearish case for rate increases for the near future. As noted, investors are expecting Trump’s policies to be pro-growth. Several of his policies (e.g. mass deportation) and potential consequences of his policies (e.g. a trade war) will significantly stifle growth. If some of these policies or consequences take effect, the shock to the system will quickly hammer the real economy and the markets. In this eventuality, it would be wise for the Federal Reserve to have amassed some credible responses to a growth recession, including rate-drops. In other words, the Federal Reserve is increasing rates now to build up a reserve of dry-powder, as a potential defense against negative consequences of reckless policy decisions.