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   Brian Wesbury
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   Bob Stein
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  History: Markets Rise Through Rate Hikes
Posted Under: GDP • Government • Markets • Fed Reserve • Stocks
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When the Federal Reserve meets next week, the question on everyone's mind will be "will they keep 'patient'?" Fed Chairwoman Janet Yellen, in her annual report to congress last month, said that the Fed will remove the "patient" language at least a couple of meetings before the first rate hike announcement. So, removing the language in this month's statement would put the Fed in line to begin raising the federal funds rates in June.

The pouting pundits of pessimism have been out in force shouting that raising short-term rates will pull the rug out from under the market, a convenient narrative for those who have been saying that this bull market is just a "sugar high."

But how has the stock market reacted to Fed rate hikes in the past? We looked back at the last twelve Fed rate hike cycles, going back all the way to 1954, and compared the S&P 500 index levels from twelve months before a first rate hike, through two years after. The results? Not only did the market not plummet as a result of increases in the federal funds rate, the market was higher in the year before a rate hike 10 out of 12 times and higher two years after the first rate hike 9 out of 12 times. On average, the S&P 500, excluding dividends, saw a 6.6% increase the year leading up to the first rate hike and a 5.9% annualized increase over the two years following the first hike.

We can't say for sure where the S&P 500 will be in two years because so many other things could happen, but the market will not get hurt by the Fed until it gets "tight." So how high will rates have to get before they become tight? The model we use to tell if fed policy is too loose, too tight, or just right is what we call the Nominal GDP model. We compare the federal funds rate to the two-year annualized percent change in nominal GDP, which combines both real GDP growth and inflation. We use a two-year average to smooth out some of the year-to-year volatility.

History has shown that when the federal funds rate is about 0.5% lower than Nominal GDP growth, Fed policy is just right, or neutral. The Fed is "tight" when the federal funds rate rises above the nominal GDP growth rate. When GDP growth is higher than the fed funds rate, Fed policy is loose. Based on our model, a neutral fed funds rate would be around 3.5% today, so any rate hikes over the next year won't cause the Fed to be even remotely tight, just a little less loose. And the Fed is likely to take measured steps in raising rates for about the first year, likely 0.25% every other meeting. So, monetary policy won't even approach "neutral" for years, assuming continued growth in nominal GDP.

Corporate profits are at all-time highs, the economy continues to expand at a Plow Horse pace, and employment continues to gain steam. While the rest of the world is slowing, the US has proven to be a beacon of strength once again. That's why the Fed will lift rates. As history suggests, this is normally a good sign, not a bad one.

Brian S. Wesbury - Chief Economist
Robert Stein, CFA – Deputy Chief Economist

Posted on Thursday, March 12, 2015 @ 10:25 AM • Post Link Print this post Printer Friendly

These posts were prepared by First Trust Advisors L.P., and reflect the current opinion of the authors. They are based upon sources and data believed to be accurate and reliable. Opinions and forward looking statements expressed are subject to change without notice. This information does not constitute a solicitation or an offer to buy or sell any security.
 
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