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Tags: Federal Reserve | interest | rate | risk

Federal Reserve Faces Mounting Risks With First Rate Hike

Monday, 06 July 2015 03:22 PM EDT

During the last year, the Federal Reserve has hinted that the period of "ultra-accommodative monetary policy" was coming to an end. The central bank started that process in October by ending the latest "quantitative easing" program that had induced massive amounts of liquidity into the financial markets. Subsequently, the Fed has turned its focus towards the near zero-percent level of the "Fed funds" rate.

Over the last several FOMC meetings, Chairwoman Janet Yellen has hinted on numerous occasions that the Fed will begin increasing the overnight lending rate sometime in 2015. She has been adamant that the Federal Reserve has been "watching the data" closely to determine the appropriate timing of those increases.

Not surprisingly, Wall Street has also been singularly focused on this issue. The increase in lending rates is the final step in ending the extremely long period of accommodative policy measures that has been a primary support of asset prices.

The problem for the Fed is that they may have already missed their best opportunity to begin increasing interest rates. The bond market may have already beaten them to the punch. While I do not expect Treasury rates to rise very much, the increase in borrowing costs in an already weak economic environment has an almost immediate impact.

Key Indicators

But it is not just interest rates that suggest that the best opportunity for the Fed to hike rates is likely behind it.

One of the important factors for continued economic expansion, and required to offset the drag caused by tighter monetary policy, is an increasing rate of wage growth to support consumption.

The correlation between wage growth and economic growth is very high. This relationship, of course, is not surprising given that the economy is almost 70 percent driven by consumption which is supported by wages.

Given that relationship, the best time for the Fed to hike interest rates is when wage growth has bottomed and is beginning to increase. The increase in wage growth leads to higher consumption that offsets the drag created by tighter monetary policy. Unfortunately, for the Fed, that window has likely already passed.

Real employment is also an issue for the Fed's ability to hike rates. Despite continued media headlines of an unemployment rate near 5 percent, the Fed has failed to lift rates. The question that should be asked is: why?

If the economy were truly running near full employment, as the U-3 rate would suggest, then the Fed should be aggressively hiking rates. The reason for the hesitancy is due to the continued "slack" in the labor force. That "slack" can be seen in the extremely low historical levels of labor force participation of the prime 25- to 54-year-old group which is at the lowest rate since the late 1980s.

The importance of this particular age group is that they are primarily responsible for household formation that supports stronger economic growth. Of course, lower employment rates, suppressed wages, and high indebtedness has made homeownership less of a reality for most. The issue of a "renter nation" is that it does not have the same economic multiplier effect that home ownership has created previously.

Furthermore, the structural shift in employment, which has suppressed wage growth, continues to impede the ability of the economy to gain substantially stronger traction. Since the end of the last recession, the number of lower-paid waiters and bartenders replaced the lost manufacturing jobs. While jobs have indeed been created, there is a huge difference between "quantity" and "quality" when it comes to economic growth.

Momentum & Complacency

Lastly, the Fed's ongoing interventions, as was their intention, inflated asset prices and boosted consumer confidence. However, the Fed should have utilized that strong momentum and relative complacency in the markets as cover for beginning their interest rate increases.

Instead, they allowed the markets to over-inflate and now run the risk, when combined with increasing global risks like Greece and China, of "deflating" asset prices too quickly this late in the market cycle.

For the Fed, the issue of tightening monetary policy at a point when employment and economic growth remain weak, can have an exacerbated effect. Historically, when the Fed has entered into an interest rate hiking cycle, the economy has been at much stronger growth rates.

The Fed has a very difficult challenge with very few options. While increasing interest rates may not "initially" impact asset prices or the economy, it is a far different story to suggest that they won't. In fact, there have been absolutely zero times in history that the Fed began an interest rate hiking campaign that did not eventually led to a negative outcome.

While the Fed clearly should not raise rates in the current environment, there is a possibility they will anyway.

The Fed understands that economic cycles do not last forever, and we are closer to the next recession than not. While raising rates would likely accelerate a potential recession and a significant market correction, from the Fed's perspective it might be the lesser of two evils.

Being caught at the "zero bound" at the onset of a recession leaves few options for the Fed to stabilize an economic decline. The problem is that it may have missed its chance to get there.

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A rising rate of wage growth is needed to support consumption and economic expansion while offsetting the drag caused by tighter monetary policy. But the Federal Reserve is caught between a lackluster jobs market and the risk of another asset bubble.
Federal Reserve, interest, rate, risk
Monday, 06 July 2015 03:22 PM
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