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Behind the Fed’s Interest Rate Hike

John Gorlow | Dec 20, 2015
Reading the Tea Leaves: 

In a widely anticipated move, the Federal Reserve announced on December 16 that it would raise its benchmark interest rate to a range of 0.25 to 0.5 percent. This is the first increase in the federal funds target rate since 2006.

Financial markets barely blinked. The 6-Month U.S. Treasury bill yield ended 3 basis points (bps) lower, the 1-Year US Treasury note ended 1 bps higher, and the 2-Year U.S. Treasury note ended 4 bps higher.

Though small, the rate hike suggests that the Fed is responding to concerns that low interest rates have distorted investment decisions, encouraged speculation and set the stage for inflation. Indeed, during the seven-year window of near-zero interest rates, stock prices soared, corporate mergers surged, and corporate borrowing hit record levels.

Rates Could Stay Low … Or Not

The Fed’s move came against a backdrop of weak global growth and an American economy that, despite improvement, has left many people unemployed or underemployed. The Fed has signaled that it will act very cautiously with an eye on domestic and global economic data and inflation. Janet Yellen and her counterparts are well aware that raising rates too quickly could undermine recovery of the domestic economy, while raising them too slowly could create market uncertainty and turmoil.  

What about the longer term? While many pundits have predicted a return to interest rates at pre-2008 levels, before the great recession, others are not so sure. 
 
According to Neil Irwin (New York Times, 15-December 2015), an examination of historical data makes it clear that “Very low rates have often persisted for decades upon decades, pretty much whenever inflation is quiescent, as it is now.” 
 
The rate on a 10-year Treasury note was below 4 percent every year from 1876 to 1919, then again from 1924 to 1958. In Britain, rates were below 4% for nearly a century. Irwin says “The real aberration looks like the 7.3 percent average experienced in the United States from 1970 to 2007.”   
 
If current Treasury bond prices are a predictor, annual inflation could be less than 2% for decades to come. Of course, markets and Fed forecasts have often been wrong, and “our understanding of what shapes inflation and growth dynamics is quite limited” says Irwin. He points out that raising interest rates doesn’t resolve the problems of the past several years including low demand, high supply and low inflation, all contributors to very low interest rates. 

In short, it is difficult to know where interest rates will be several years from now. The high inflation of the 1970s and 1980s may have been an abnormality, and very low inflation that the world is experiencing today may be the new normal. Or not. 

As always, we can project and predict, but the market’s ability to reflect the probability of different outcomes and events in security prices reinforces the greater importance of focusing on asset allocation and diversification as opposed to parsing information from “news” in an attempt to forecast future market activity. The safest way to deal with interest rates, whether rising or falling, is to accept with what the market has to offer, maintain a long-term perspective and properly allocate financial assets based on one’s risk tolerance, income and liquidity requirements, total return objectives, and age and life circumstances.