Perhaps we are misreading the Fed’s intentions going forward because multiple Fed officials are signaling the Fed’s intention to raise interest rates multiple times in 2016 and 2017. And while rate hikes are usually considered tightening, to the degree financial market volatility and energy sector debt stress have diminished, rate hikes could be a wash given the interest income they add to the US private sector.
Let’s start with San Francisco Fed President John Williams. He was in New York making the following comments:
- He expects 2% growth (what I am calling the border between normal and stall speed)
- Lower inflation expectations worry him and global events are headwinds for the US
- But that is not enough to put him off hikes because he believes the US is at full employment
- He sees inflation moving up and expects 2-3 hikes in 2016 plus another 3-4 in 2017
- He also says the Fed will keep balance sheet as is, allowing it to shrink organically at some point later
The overall tenor of these comments are hawkish, to say the least because the market is pricing in 2 rate hikes through the end of 2017 and Williams is saying he expects 5 to 7 hikes in that time frame. This is off the charts hawkish compared to what markets are expecting. So it will be important to see how financial markets respond since they have responded poorly in the past when the Fed has talked of tightening.
Then there’s James Bullard at the St. Louis Fed. He say,s “Labor markets are relatively tight. This may put upward pressure on inflation going forward.” He also said that keeping rates too low for too long could create future financial instability, intimating raising rates now would ward this off. While his comments were more general in nature, it is clear he is in favor of raising rates.
Finally, there is Boston’s Eric Rosengren, who says that the US is on the cusp of meeting pretty much all of the economic pre-conditions the Fed has put in place for hiking rates. His exact comments were “I want to be sensitive to how the data comes in, but I would say that most of the conditions that were laid out in the minutes, as of right now, seem to be . . . on the verge of broadly being met.” Now before the minutes of the April meeting came out, markets thought that there were low odds of a June hike. But now, after the minutes and these statements, the markets are definitely going to see the possibility as much greater.
My view here is that rate hikes are not always tightening. They tighten to the degree stimulus has been felt through eased financial conditions and to the degree that debt stress overrides interest income needs. But right now, while debt stress is still apparent, the loss of interest income is such a palpable factor that the income effect of rate hikes may entirely offset the negative impact on equities and on debtors in dire need.
My expectation at this time is that, if the Fed does hike, it will flatten the yield curve and that long rates will go up less than short rates. And this will negatively impact bank net interest margins. But on the whole, the economy will not tip into recession, Instead it will continue around its 2% growth path or slightly below.