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Tags: Lance Roberts | Fed | rates | hike

Fed Risks Missing Window to Hike Rates Before Next Recession

Lance Roberts By Friday, 12 June 2015 01:29 PM EDT Current | Bio | Archive

The Federal Reserve for the past year has repeatedly discussed a potential increase in the overnight lending rate. That "Fed Funds" rate has been held at a historical low of 0.25 percent for an unprecedented 78 months and counting, as the economy struggles to recover from the last recession.

The Fed uses monetary policy to control inflationary pressures, or maintain price stability, and stimulate employment. This is the Fed's “dual mandate," which is an important concept to understand when discussing the central bank's policies.

During the financial crisis, the Fed drastically lowered rates in an attempt to stimulate economic growth and employment, and to boost inflationary pressures. The near-zero interest rate policy was supposed to spur consumers and businesses into action by using low borrowing costs to jump-start economic growth.

The problem for the Fed has been that while the economy did stabilize, exceptionally low interest rates and massive quantitative easing programs have been unable to put "Humpty Dumpty back together again."

In recent months, the Fed has become much more vocal about the probability of increasing interest rates sometime in 2015. Early speculation was that rate hikes would begin around mid-year, but the recent spate of economic weakness has pushed expectations out to later this year.

However, with the recent decline in many of the economic indicators, combined with the sharp fall in inflationary pressures, the question is: Why would the Fed risk tightening monetary policy at such a critical juncture?

It understands that economic cycles don’t last forever, and we are closer to the next recession than not.

While raising rates would likely accelerate a potential recession and a significant market correction, from the Fed's perspective if just might be the lesser of two evils. Being caught at the "zero bound" at the onset of a recession leaves few options for the Fed to stabilize an economic decline. The problem is that it already might be too late.

The Fed is hoping to lift interest rates from zero while the economy and inflation remain at sub-optimal levels.

Therefore, rather than lifting rates when average real economic growth was at 3 percent, the Fed will not start this process at less than half that rate.

Think about it this way. If it has historically taken 11 quarters to go fall from an economic growth rate of 3 percent into recession, then it will take just one-third of that time at a rate of 1 percent, or three to four quarters.

This is historically consistent with previous economic cycles, suggesting there is much less wiggle room between the first rate hike and the next recession than currently believed.

Treasury Rates Jumping

While the Fed hopes that they can effectively raise interest rates without cratering economic growth, the problem is that the bond market may have already beaten them to the punch.

While I do not expect Treasury rates to rise very much, the increase in borrowing costs in an already weak economic environment has an almost immediate impact. The Fed is hoping that they will be able to safely raise borrowing costs in the months ahead, but the recent surge in rates will quickly affect the housing, auto and other variable rate credit markets that support consumption.

It is important to remember that while interest rate movements from very low levels have little actual effect on payments, it is the psychology of consumers that is affected.

Consumers buy payments — not houses, cars or other items. If interest rates go up, consumers tend to reduce activity either because they cannot afford the new payment or in hopes that the previous cheaper rate will return.

This is a challenge facing the Fed. If the recent spike in interest rates continues, the economy will begin to show further signs of weakness. This will make it much more difficult for the Fed to hike rates in the future.

Any action the Fed does take to "tighten monetary policy" will only exacerbate the effect that the recent surge in Treasury rates is already having.

The Fed may have missed their window for hiking rates for the time being. However, the clock is ticking toward the next recession, and this could be a real problem.

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If the recent spike in interest rates continues, the economy will begin to show further signs of weakness. This will make it much more difficult for the Federal Reserve to hike rates in the future.
Lance Roberts, Fed, rates, hike
Friday, 12 June 2015 01:29 PM
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