Washington Trust Bank Blog | Message From the Federal Reserve: An Interest Rate Increase is Coming

Message From the Federal Reserve: An Interest Rate Increase is Coming

The Federal Reserve released the minutes from their July meeting and there was an interesting market response to the minutes.

For those of you who are “Game of Thrones” fans, you know that the favorite saying on the show is “winter is coming”. The minutes from the July meeting told the markets: “It’s not time to raise rates yet, but an interest rate increase is coming”.

The minutes did reflect that a few of the meeting participants were worried that inflation might not rise fast enough to warrant a rate increase this year. Some also expressed concern that economic growth in the 2^nd half of the year might not grow as fast as expected because of potential negative impacts from lower oil prices, a stronger dollar and weakening growth internationally. This was not the majority opinion. The majority felt that the positive benefits from jobs growth, increased net worth via rising home values, lower gas prices and lower import prices would help improve economic growth in the second half of the year.

Remember that the Federal Reserve has stated that two conditions need to be met to raise rates:

1. The labor market has to improve sufficiently to support a rate increase, and
2. The Fed has to be confident that inflation will rise back to their 2% target level.

The press release essentially said that the Federal Reserve believes that these two conditions are approaching levels that justify a rate increase in the near future.

The interesting response from the markets is that they chose to focus on the dissenting opinions rather than the majority opinion.

1. The bond market saw prices increase as they interpreted the minutes to reflect that the Federal Reserve may be more worried about low inflation and slow economic growth than they are publicly admitting.

2. The currency market saw the dollar decline as they interpreted the minutes the same as the bond market.

3. The equity markets initially rallied over the thought of a potential delay in raising rates, but then gave up all of their gains as they worried that a delay in raising rates means an economy that is not improving as fast as the Federal Reserve desires.

 

I believe that unless the economic data truly weakens more over the next month, the Federal Reserve will raise rates this year-and probably in September-for the following reasons:

1. They have a credibility issue if they don’t raise rates because they have spent all year telling the markets that they will raise rates this year.

-They do not want to be labeled “The Fed Who Called Wolf”.

2. The economy no longer warrants the “emergency” measures (i.e. near zero interest rates) that existed when the Federal Reserve brought rates to near zero.

-A 25 basis point increase in rates (if they even raise it that much) is still a very accomodative stance from the Federal Reserve.

3. The Federal Reserve truly believes that the first quarter was an anamoly and that economic growth will continue to improve.

-The Federal Reserve is relying heavily on their believe that continued solid jobs growth will ultimately lead to higher wages and higher spending.

4. Public statements from Federal Reserve members that have occurred after the July meeting reflect confidence in the economy and a desire to raise rates in September.

-One Federal Reserve member (Lockhart) went so far as to say that he would have to see dramatic slowing in the economy before he would change his mind on a September increase.

Whether those reasons are truly enough to warrant an interest rate increase is open for debate. I can make the argument that the Federal Reserve may be risking making the same mistake that the Bank of Japan has consistently made by raising rates too soon. The important point is that it does not matter what the markets or I may believe, it is what the Federal Reserve believes that will determine when they will raise rates.

 

 

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