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  Fed Teeing Up Rate Hike
Posted Under: Government • Inflation • Monday Morning Outlook • Fed Reserve • Interest Rates

Just a couple of weeks ago the odds of the FederalReserve raising rates in June were slim to none. The federal funds futuresmarket put the odds of a rate hike around 4%.

Then, last week, we got the minutes from the Fed meeting back in April, whichshowed that as long as the economy continued to make progress the Fed was verycomfortable with a June rate hike. Now, the futures market is putting the oddsof a 0.625 percent interest rate on fed funds at about 30%.

We think those odds will move higher over the next few weeks and a rate hike inJune is more likely than not, say about 60%. Not definite, not 100%, just muchhigher than most investors now expect.

But none of this should concern equity investors. Monetary policy will still beloose and remain that way for an extended period of time. Consumer prices areup 1.1% in the past year while "core" consumer prices are up 2.1%.So, either way, the federal funds rate will remain well below inflation,meaning the "real" (inflation-adjusted) federal funds rate staysnegative.

Meanwhile, the banking system is still chock full of $2.3 trillion in excessreserves (reserves in excess of what banks are legally required to hold to meetreserve requirements). Raising rates is not going to change that. It will,however, mean the Fed pays banks more to hold these reserves, a plus forfinancial firms and, in turn, money growth. M2 has grown 9.4% at an annual ratein the past three months, while commercial and industrial loans have grown16.1%.

Raising rates should help the Fed get in a position where it can eventuallystart drawing down those excess reserves. But, until it does, the chance ofsharply accelerating money growth exists. This will bring more inflation.Normally, higher short-term rates tend to flatten the yield curve, withlong-term rates moving up, too, but not as much as short-term rates.

But this time really is completely and totally different. Raising rates makesmoney growth accelerate because of all the excess reserves out there.

One reason some analysts and investors still think the Fed won't raise rates inJune is that it hasn't clearly telegraphed that it wants to raise rates. But wethink the absence of a clear signal is because the Fed is rethinking itsposition on transparency.

Time and again over the last several years, the Fed has indicated a shift inpolicy was imminent only to reverse course when short-term gyrations infinancial markets scared the snot out of everyone. People still talk about thetaper tantrum. We always said this was an over-reaction on everyone's part.

In the end, the Fed eventually tapered, ended quantitative easing and thenraised rates as well, without negative economic consequences. So the Fed maynow think that if the economy deserves slightly higher rates, the best thing todo is
not make it clear it will raise rates beforehand (because marketsmight throw a fit), and just pull the trigger. Tapering, ending QE, and raisingrates in December didn't hurt growth, so why not raise rates again withoutgenerating any hysteria before the action takes place?

There is still time for the data to get worse before the Fed makes its decisionin mid-June. We just don't think that's going to happen. Instead, look forreports on durable goods, consumer spending, inflation, and the job market togive the Fed the confidence it needs to get back on track toward a more normalmonetary policy.

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Posted on Monday, May 23, 2016 @ 11:10 AM • Post Link Share: 
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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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