Whenever the Fed raises rates to lean against the headwinds of inflation it is referred to as taking away the punch bowl. We owe this analogy to William McChesney Martin, who was head of the Federal Reserve for 19 years starting in 1951, the longest tenure of any Fed Chairman. Hard to see any Fed Chairmen lasting as long today, especially if they are known for shutting down the party just as it gets going!
Last week the Federal Reserve raised the target Fed Funds rates for only the second time since the financial crisis. The target is now just 0.50% to 0.75% compared with the actual rate of 5.25% at the end of 2006. With rates still so low, this is hardly taking away the punch bowl—more like Janet giving the partygoers a sober look (see below). The market had expected this look. However, the Federal Reserve went a bit further than the market anticipated at this meeting by announcing it may raise rates three times in 2017, and even further in 2018. The partygoers found this a bit concerning, and interest rates rose while stocks fell.
However, the markets may be getting a little ahead of themselves. First, even the Federal Reserve does not see any quick move to faster growth or inflation. In its meeting last week, the Fed increased its projection for GDP growth in 2017 from 2.0% to 2.1% and even kept the PCE inflation rate target the same at 1.9%. The Fed also dropped its unemployment forecast from 4.6% to 4.5%. Second, while the markets are excited about the Trump administration’s pro-growth policies (including tax reform, looser regulation and increased infrastructure spending), as we unpack these promises, it becomes apparent that delivering on them will be difficult and will take time. Third, we see headwinds to U.S. growth coming from an anemic Europe and Japan, a slowing China, high debt levels around the world and a stronger dollar. Finally, as we discuss in the note below, there are certain technical factors pushing up interest rates at this time.
As we analyze portfolios, we are taking a balanced view that growth and inflation could be somewhat slower than both interest rate volatility and the stock market are predicting. Portfolios continue to earn income, and the ability to reinvest interest and principal at higher rates is a good thing. The markets are not always totally rational, especially when the punch bowl has been out on the table for the last eight years!
Source: The Federal Reserve, Bloomberg, The Financial Times