January 27, 2016

Fed Hits Pause on Rate Hike

The Fed, as expected, hit the pause button on its plan to hike interest rates following its FOMC meeting today. The sell-off in the stock market and oil prices are adding to the of cross currents about the health of the economy. The Fed hiked short-term rates last December, the first time in almost 10 years. Its target range is currently 0.25% to 0.5%, very low by historical standards. The Fed indicated that it may increase its target to about 1.25% in 2016, which it believes would be consistent with inflation around 2%.

The challenge for the Fed is balancing U.S. job growth and price stability. Recent news suggest that the US and global economies may be slowing. Even though the US job market is healthy, we expect the Fed to be sensitive data that points to deterioration in the outlook for jobs. It has kept interest rates low to support economic growth and jobs. Standard lessons from economics say that inflation increases if interest rates are too low for too long. The problem is that rates have been extremely low for almost a decade, but inflation is still running below its 2% target.

I do not agree with market pundits that believe that the Fed will keep rates low to support the stock market. Lessons learned from my time at the Fed and acting as a Fed Watcher during my time as a Wall Street economist is that the Fed’s decisions are more about jobs and inflation. I would look for the Fed to act if it believes that a sell-off in stocks will derail the trend in job growth. Barring concerns about job growth, I would look for the Fed to stay its course.

Based on current trends, I continue to expect the Fed to raise rates roughly once every other or third FOMC meeting. Although Fed officials indicated earlier that its target range may be near 1.25% by the end of 2016, I think it will be closer to 0.75%. The economy needs to show better job conditions and price gains making good progress toward 2% inflation for the Fed to make good on 1.25% target.

We expect the Fed to announce changes in its interest policy after its FOMC meetings. It will meet seven more times in 2016 in March 15-16, April 26-27, June 14-15, July 26-27, September 20-21, November 1-2 and December 13-14. It is unlikely, but the Fed can change policy in between meetings if necessary.

What all this means is that interest rates overall should remain low by historical standards. However, short term interest rates should end 2016 higher than they are now. Long term interest rates, which are influenced more by inflation expectations and demand for a safe haven investment, will likely remain near current levels. Borrowers using floating-rate loans, which are usually tied to short term rates, will likely see rates edge higher. Borrowers of fixed-rate loans such as 30-year mortgages, which are linked to trends in long-term rates, will likely see rates near current levels.


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