Wednesday, December 16, 2015

The Fed Moves: At Last

Seven years ago today, in response to a very real financial emergency, the Fed embarked upon its zero interest rate policy. With the emergency long over the Fed finally acted by raising the federal funds rate by 25 basis points. Because the rate rise was accompanied by very dovish comments the stock market rallied smartly and the bond market, which had correctly priced in the move, ended the day substantially unchanged.

There are three points to take note of:
1. Monetary policy remains extraordinarily accommodating. My analogy is that on a 65 mph speed limit highway, instead of going 90 mph the car has slowed down to a still excessive 85 mph. Thus today's move is unlikely to slow the economy and in fact with the Fed signalling that the emergency is over, the economy could very well speedup.
2. Markets are way too complacent about inflation. With the core CPI increasing at a 2% rate yoy it won't take much for the Fed's personal consumption deflator to be there as well. Moreover housing costs, health care and other services are reporting inflation rates well above 2%. Once oil prices stabilize and likely reverse their recent decline most of the ingredients will be in place for an upside surprise in the inflation data. Stay tuned!
3. If you closed your eyes and I told you that core inflation was 2%, the unemployment rate was 5%, GDP growth is above 2%, and the stock market is close to an all time high, what would you guess the fed funds rate to be? It would be quite a bit higher than .25%-.5%. 

Net Net. Interest rates will surprise on the upside.

1 comment:

  1. You may be right but then the economy would be much closer to recession than the Fed expects.