Why Have Interest Rates Risen Recently? Perception Versus Reality

Interest rates have risen recently due largely to how financial markets have interpreted comments from Federal Reserve (Fed) presidents and minutes of the last Federal Open Market Committee (FOMC) meeting that were released. The question is whether the rise in interest rates is based on perception or reality. My vote is that it has been a reaction created by the market’s perception that the Federal Reserve has changed their stance regarding the timing of interest rate increases. I believe that the reality is that they have not changed their stance but were trying to recalibrate market expectations.

Let’s take a look at what the Fed said and what the economic data has told us since the last FOMC meeting.

Atlanta Federal Reserve President Dennis Lockhart and San Francisco Federal Reserve President John Williams both gave speeches in front of the release of the April FOMC meeting minutes. In their speeches they warned the financial markets that they may be underestimating how many interest rate increases could occur this year. They also stated that they believed that an interest rate increase at the June FOMC meeting was on the table and open for discussion, depending on how the economic data played out. The reaction from the financial markets was essentially “Uh oh, is there something in the upcoming minutes that we do not know about? Are they giving us a prelude to a surprise in the minutes?” As a result of this perception, interest rates began to rise. On Wednesday (5/19/16) the Fed released the minutes from their April 26-27 meeting. There are 13 pages of those minutes and yet the financial market chose to focus on these 55 words:

“Most participants judged that if incoming data were consistent with economic growth picking up in the second quarter, labor market conditions continuing to strengthen, and inflation making progress toward the Committee’s 2 percent objective, then it likely would be appropriate for the Committee to increase the target range for the federal funds rate in June”.

The financial markets responded negatively to those words and interest rates rose further.

So, let’s focus on reality. If we pay attention to the conditions that the Fed laid out in those 55 words, have the conditions been met?

1. Economic growth picking up: Since April 26^th, there have been 50 major economic data points released.
   1. 26 were better than their March data;
   2. 24 were weaker than their March data.
2. Labor market conditions continuing to strengthen:
   1. The April jobs report showed weaker jobs growth than March.
   2. Initial jobless claims as of May 19^th, are higher (278,000) than the April 21^st report (247,000)
3. Inflation makes progress toward the Committee’s 2 percent objective:
   1. The most recent Personal Consumption Expenditure Index ex-Food and Energy (the Fed’s inflation measure) fell from 1.7% to 1.6%

Based on reality, the criteria that the Federal Reserve laid out for considering an interest rate increase in June have not been met. Whether we see a surge in strength over the next 30 days remains to be seen.

So, why would the Fed make comments that roiled the financial markets? This is one man’s opinion (mine) and do not necessarily reflect the views of Washington Trust Bank or senior management. My scenario is this:

Page 11 of the minutes contained this note:

“Some participants were concerned that market participants may not have properly assessed the likelihood of an increase in the target range at the June meeting, and they emphasized the importance of communicating clearly over the intermeeting period how the Committee intends to respond to economic and financial developments.”

I believe that the Fed speeches and the minutes were both attempts to recalibrate financial market expectations regarding the timing of interest rate increases.

1. The Fed has been frustrated that the financial markets have essentially cancelled their monetary policy action of raising short-term interest rates. Since the Fed announced their decision to raise the short-term Fed Funds target range by .25%, interest rates have steadily declined due to weak economic data, financial market volatility and foreign investor demand.
2. The financial markets have consistently been forecasting a smaller rate of increase in the Fed Funds rate than what the Fed’s guidance has indicated. The Fed has consistently lowered their “dot plot” expectations for where Fed Funds would be by the end of the year and this gave the financial markets the confidence that they were right and the Fed was wrong.
3. The Fed grew concerned that the financial markets were painting the Fed into a corner by continuing to lower the expectations for interest rate increases.
4. The Fed became alarmed when the futures market had virtually eliminated any belief that the Fed would raise rates this year.
5. The Fed worried that financial markets would react violently if they let the markets continue with their belief in no interest rate increases this year.
6. The Fed wanted to send a message to the financial markets that it is the Fed who decides when to raise (or lower) interest rates and not the financial markets.
7. The Fed felt that making that clear now would mitigate any market reaction versus waiting until later in the year.
8. The financial markets responded the way the Fed hoped and recalibrated their expectations for interest rate increases in 2016. Immediately after the Fed Presidents’ speeches, the futures market adjusted the odds for a June increase from 4% to 18%. Immediately after the release of the FOMC minutes the futures market adjusted the odds for a June increase from 18% to 34%.
9. The financial market reaction has now given the Fed a little more breathing room without actually changing the Fed’s decision making process.
10. Mission accomplished?

Recent Federal Reserve communications and the financial markets’ reaction to the communications indicates that “Fed Speak” remains an “arrow” in the Fed’s monetary policy tool “quiver” when they want to adjust the financial markets’ perception to be closer to what the Fed views as reality.

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