When will the Fed raise interest rates?
History shows that the unemployment rate will be key
All eyes were on the Federal Reserve Wednesday as investors awaited the outcome from its two-day policy meeting.
As expected, interest rates were left unchanged as economic conditions "warrant exceptionally low levels of the federal funds rate for an extended period." However, policymakers did optimistically note the increased activity in the housing sector as well as the uptick in consumer spending. The largest change was a $25 billion reduction, to $175 billion, in the amount of mortgage debt the Fed will purchase. It will still buy $1.25 billion worth of mortgage-backed securities.
History shows policymakers have never increased the cost of credit while unemployment is rising. In fact, the Fed has waited at least six months after the peak in unemployment and when the unemployment rate has dropped by 0.7% from its high before hiking rates. Moreover, during periods of low to no inflation like we have now, the Fed can wait twice as long before raising rates.
With all this said, maintaining a near-zero interest rate policy will become increasingly uncomfortable even for a dyed-in-the-wool money printer like Fed chair Ben Bernanke. Global overseers of the financial system including the World Bank, the International Monetary Fund, and the Bank for International Settlements are all out warning that cheap money is fueling new asset bubbles in Asian stocks and real estate.
Given their forecast for unemployment -- peaking at 10% this quarter before falling back to 9% in the latter part of 2010 -- Deutsche Bank economists expect the first tightening of 0.25% to occur at the Fed's August 2010 meeting. They see another 0.25% hike the ensuing September meeting to be followed by a 0.5% hike at the November meeting. After that, the team expects 0.5% hikes during alternating meetings. This will bring short-term interest rates to 1.25% next year and 3.25% in 2011.
But of course, ultra-low interest rates weren't the only policy tool the Fed used to fight the Great Recession. Various rescue programs, along with unconventional "quantitative easing" strategies that saw the Fed make direct purchases of U.S. Treasury debt and mortgage securities, has more than doubled to Fed's balance sheet to over $2 trillion. Some believe that the Fed will start to sell off its assets, thereby pushing up long-term interest rates, before it raises its short-term policy rate. This would raise both mortgage rates as well as the government's cost of borrowing.
Because of the worries over the federal deficit as well as the fragile state of the housing market, I don't think this is likely. Instead, I expect the Fed will increase the interest rate it pays to banks that park extra cash in its vaults instead of lending it out. This helps suck extra dollars out of the system while not disrupting the bond market with an influx of supply.
Translation: Starting late next year, look for the Fed to start raising both its policy rate as well as the interest rate it pays to banks. Mortgage rates and other long-term interest rates should start creeping higher next spring as the Federal Reserve ends its direct purchase program. But a large spike in rates will be avoided as the Fed slowly sells the debt it's already purchased.
Disclosure: The author does not own or control a position in any of the funds or companies mentioned.
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