No Reason to Fear the Fed

Submitted by Raul Elizalde on Tuesday, February 10, 2015 - 9:00am
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One day, the Federal Reserve’s long-running stimulus will end – and that provokes a lot of investor anxiety. Fortunately, those fears are overblown.

The end of the stimulus means that interest rates will start to go up, and that the Fed will begin to sell trillions of dollars’ worth of securities it bought during a program called quantitative easing, or QE. The market is afraid that interest rates could go up a lot, or that the Fed will dump the securities quickly, or both. Either scenario could be quite disrupting.

Interest rate hikes and security sales are likely to be gradual and predictable, as the Fed itself has committed to do in writing (in the “Policy Normalization Principles and Plans” of September 2014). More to the point, nothing will happen soon. But the market is afraid nonetheless.

The concern that interest rates could rise a lot stems from past Fed moves. Last time the fed funds rate (the central bank’s goal for short-term rates) went up, in 2004, it soared from 1% to 5.25%. The time before that, in 1994, it climbed from 3% to 6%. And before that, in 1987, from 5.87% to 9.75%. This suggests that the Fed does not fool around when it changes policy.

Accordingly, the market seems to think that once the Fed sets out to change course it will do so with a damn-the-torpedoes approach, ignoring all sorts of dislocations in the prices of securities and bringing the economy to a grinding halt.

This is evident by the market reaction to news. Anything that pushes forward the starting date, like soft data or a dovish statement from a Fed official, sends the market up. Strong data or hawkish comments, however slight, send the market down. The media’s obsessive focus on Fed policy makes this worse.

Investors should relax. The Fed is a long way off from changing course in any meaningful way. First, it said, in its last statement, that “it can be patient in beginning to normalize monetary policy.” Also, the Fed stated that interest rates will remain where they are for a “considerable time” as long as inflation runs below its 2% target and “employment objectives” remain unattained. Both conditions are likely to remain in place for a while.

Deflationary pressures around the world will keep U.S. inflation below 2% for the time being. It rose just 0.8%, as of December, from a year before. The eurozone is now officially in deflation (prices fell 0.2%), and China’s inflation numbers (1.5%) keep falling. Reuters recently quoted a Citicorp economist in Hong Kong, saying that “deflation [in China] this year is definitely a risk.” All indications point to U.S. inflation remaining where it has been for the past two and a half years, well below the 2% target, for most of this year.

The Fed’s employment objectives are a bit more difficult to define. The official measure of employment the Fed follows, forecasts and targets, is the unemployment rate. But employment objectives may now include wage growth, which Janet Yellen, the Fed’s chair, spotlights as a key factor in judging the economy’s health. Trouble is, during discussions at Fed meetings, a definition of this measure has not emerged.

So as long as wages remain weak, policy changes are unlikely. And so far, wages display very little improvement relative to the rest of the economy, as we noted previously. The last employment number release, in fact, shows the steepest one-month decline in private hourly earnings since the U.S. Bureau of Labor Statistics started the series. The year-on-year rate of wage growth has now gone down four months in a row, according to my calculations from St. Louis Federal Reserve wage growth data.

Things, of course, could change. Economic growth is picking up, and wages could start rising. If so, the Fed may start normalizing policy sooner. For now, however, the data shows no reason for that.

What about the Fed’s balance sheet? The Fed bought an enormous amount of bonds and mortgage-backed securities to bring down long-term interest rates and to inject money into the economy. It achieved the first goal: Market rates went down a lot.

But the money the Fed wanted to supply to the system to spur spending ended up deposited back at the Fed instead, in the form of excess bank reserves. This extra safety cushion for the banks means that they had less money available to lend.

The extent of how much money took this round-trip is remarkable. Excess reserves that banks hold at the Fed now equal the entire stock of money in circulation, or M1.

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Some see the accumulation of excess reserves as a partial failure of monetary policy: A lot of the money created by the Fed never reached the real economy. However, there is a silver lining to this.

When the Fed finally decides to start taking back some of that money, excess reserves initially will decline. This will have a very small impact, if any, on economic activity, because excess reserves are not put to any kind of productive use anyway.

Another fear is that, if the economy starts to heat up, loan demand could cause all those reserves to gush suddenly into the economy before the Fed has a chance of reducing its balance sheet. This could spark the inflation that some have predicted (wrongly) for years. Because the third quarter 2014 gross domestic product reading came at a rather robust 5%, this is a reasonable concern.

But the Fed has said, in its Policy Normalization plan, that it intends to move rates by adjusting what it pays on those excess reserves (currently 0.25%). This is a way of controlling the supply of funding to a sudden increase in the demand for loans. Despite loud criticisms of the central bank’s novel policies, the Fed has several tools at its disposal to steer policy back to normal. Thankfully, the central bank also seems to be quite capable of using them.

A change in Fed policy is a monster under the bed keeping investors awake at night: scary, but not real. No doubt, there are always reasons to worry. But investors who think their main threat today is U.S. monetary policy are looking in the wrong place.

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Raul Elizalde is president and chief investment officer of Path Financial LLC Investment Management in Sarasota, Fla., where he writes the e-letter Straight Talk.

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