A hawkish Federal Reserve is here

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The Federal Reserve recently announced that it is raising the benchmark target federal funds rate by a quarter of a percentage point. This is the seventh consecutive increase in the benchmark rate, a trend that began in December 2015. The rate now stands in a range from 1.75 percent to 2 percent, the highest level since the global financial crisis. While this was the least surprising Fed announcement in recent memory with virtually all pundits predicting the increase, the narrative accompanying the move indicates the Fed is becoming more hawkish.

Fed pronouncements are not generally straightforward or colorful. Analysts typically spend time parsing the carefully crafted statements for clues on the future course of monetary policy. Former Fed Chairman Alan Greenspan himself is quoted as saying, “What I’ve learned at the Federal Reserve is a new language, which is called ‘Fed speak.’ You soon learn to mumble with great incoherence.” Current Fed Chairman Jerome Powell did not mumble during the announcement, saying, “The main takeaway is that the economy is doing very well.” He added, “Most people who want to find jobs are finding them, and unemployment and inflation are low.”

{mosads}The Fed has a dual mandate of achieving full employment and stable prices. On the employment front, the news simply could not be much better. Unemployment stands at 3.8 percent, which is the lowest level since 2000. The Fed believes that unemployment will fall even further to 3.6 percent by the end of the year. This is actually below the long-term natural rate of unemployment of 4.65 percent estimated by the Fed.

Real GDP grew at an annual rate of 2.2 percent in the first quarter of 2018. The Organization for Economic Cooperation and Development estimates that full year real GDP will grow at 2.86 percent in 2018 and 2.78 percent in 2019. These estimates are higher than any realized growth rates in the previous 10 years. While we can debate how much credit the Trump administration should receive for the state of the economy, the numbers suggest that, as Powell indicated, the economy is doing well.

As to the second part of the dual mandate, which is stable prices, the Labor Department announced that the producer price index climbed by 0.5 percent in May. The consensus view was that it would only rise by 0.3 percent, up from the 0.1 percent increase in April. While much of May’s rise was due to higher energy prices, the larger than expected increase confirmed that the Fed needs to ensure that inflation remains modest.

Since 1955, the average effective federal funds rate has been 4.8 percent, and the rate has been at unprecedentedly low levels since the global financial crisis. The Fed wants to normalize interest rates so that if the economy slows at any point in the future, it has the tool of lowering interest rates at its disposal to potentially jumpstart the economy and either avoid a recession or lessen its impact.

While it is true that holding all else equal, rising interest rates are generally bad for the value of financial assets, notably stocks and bonds, context is important. Investors should view the recent rate hike as confirmation that the economic outlook is rosy and the Fed believes that it will not forestall a recovery by raising rates today and over the next couple years.

Investors are particularly squeamish because stock market returns have been so strong since the depths of the financial crisis. From 2009 through 2017, the annual return of the S&P 500 has been 15.3 percent. At some point we simply have to experience a significant correction. The problem is that as the old Wall Street adage says, no one rings a bell at the top of the market. Some bull markets last a lot longer than average.

In a joint interview on CNBC, Berkshire Hathaway chairman Warren Buffett and JPMorgan Chase chairman Jamie Dimon both indicated they believed that the economy was doing well. Buffett said, “Right now there’s no question it’s feeling strong.” In typical fashion, he invoked a baseball analogy, adding, “If we are in the sixth inning we have our sluggers coming to bat right now.” Investors should let those sluggers hit.

Robert R. Johnson is principal at Fed Policy Investment Research Group and former president of the American College of Financial Services. He is the co-author of “Strategic Value Investing” and “Invest with the Fed.”

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