The Fed Needs To Raise Interest Rates Soon

By Vincent J. Truglia

I know I have been incommunicado for a while, but I have been working on a major project for the Bertelsmann Foundation, which has kept me pretty busy.

FOMC

Most of my readers know that the Federal Reserve’s Federal Open Market Committee (FOMC) is having its monthly two-day meeting to decide on monetary policy today and tomorrow. The only issue investors are interested in is when the Fed intends to raise short-term interest rates.

NAIRU

The problem, as I see it, is that the US economy is performing adequately. Unemployment is down more in the last five years than it was in seven years following the back-to-back recessions we experienced during the Reagan administration. That sounds pretty good to me. We economists can spend years debating the non-accelerating inflation rate of unemployment or NAIRU – that’s certainly a mouthful. In other words, the rate of unemployment consistent with low inflation or a non-inflationary environment. The May unemployment rate came in at 5.5 percent, or slightly above April’s 5.4 percent. However, the reason for the slight increase was that more people returned to the labor market. That is a sign that the economy is definitely, not just on the mend, but is recognized by most people as performing well.

It is definitely not healthy to keep short-term interest rates near zero in perpetuity. The problem is that the FOMC appears to have gotten a little too emotional regarding its decisions. Yes, there are still a lot of unemployed people, and yes, market volatility is increasing. However, market volatility has risen for a myriad of reasons ranging from the on-going Eurozone saga, slower growth in China, a mega-drought in Brazil, and debates over if and when the Fed will raise rates. The Fed should only take into account asset price volatility if such volatility threatens the US payments system. Frankly, all these risks out there are well known.

Investors Beware

Any investors, including large financial institutions that don’t already understand that, deserve whatever happens to them when interest rates in the US begin their ascent. There are plenty of ways investors can hedge against volatility risk. Yes, there is a problem with measuring the outcome of this increased volatility, but that is well within the modeling capability of the largest institutions. If not, they should simply hire some new mathematicians and physicists to do the calculations.

Why A Rate Hike Now?

Why am I so adamant about the need for a rate hike? The reasons are quite straightforward: 1) Keeping short-term rates near zero must ultimately come to an end; 2) Low rates over such a prolonged period have distorted asset prices in a way which is difficult to measure; 3) The US economy is performing relatively well, at least compared to most of the rest of the world; 4) Unemployment is at a reasonable level; and, 5) the US will likely hit capacity constraints sometime in 2017.

Capacity Constraints

The last point is by far the most important. When the US hits full capacity, inflationary pressures will mount. Already, we can see inflationary pressures beginning to appear. Wages for skilled and semi-skilled workers are rising. Consumer prices, year-over-year, excluding volatile food and energy prices are already rising by 1.8 percent, or only slightly below the magic 2.0 percent target. Other measures of inflation remain somewhat muted, but overall, the US no longer appears to face the risk of deflation.

The problem now is that if the Fed doesn’t start to raise short-term rates in small increments this year and next, it will likely be faced with the need for larger increases in rates by year-end 2016 and definitely by 2017.

If the Fed postpones the inevitable, then if the increases are similar to what the Fed did in the early 1990s, the Fed could plunge the US economy back into recession. However, if it starts with very small rate increases, and clearly indicates it will take small steps over time, then markets will have been given enough information to adapt to a rising interest rate environment.

Keep The Increments Small

Although the Fed usually adjusts interest rates by 25 or 50 basis points, I would argue that the Fed should also consider raising rates by as little as 10-15 basis points. It would appear unlikely such a small increase would derail the economy. In fact, if the Fed starts to raise rates, even at this meeting by a small amount, it is possible that over time, long-term interest rates might actually decline modestly. Inflation fears would be muted by the knowledge that the Fed will not let inflation rise too much.

If it waits until September, then the increases will have to be in 25 basis point increments to get rates where they need to be in 2016. The far better path is for the Fed to have the courage to start raising rates this month, or next month at the latest, but by as small an increment as possible.

As always, Clear and Candid.