Minutes were released from the most recent Fed meeting yesterday. In it, perhaps the most prominent message was “We haven’t forgotten about raising interest rates.” Today, I’m going to talk about where we are, where we are going in the next year, and where we are going beyond that.
Today, we find ourselves in a low interest rate environment that has persisted for 7 years. Fed officials have communicated consistently that they have wanted to raise rates, but that they have been waiting on the US economy to show sustained signs of recovery before doing so. They have been seeing signs of continued expansion, but they are wanting to see more of them. The first quarter was slow, but Fed officials anticipate a better 2nd quarter. Rates around the world are low. Japan continues to experiment with negative interest rates – so far with poor results. Meanwhile in Germany a 10-year bond will fetch an investor a mere .20%. These low yields world-wide create demand for more attractive US bonds with 10-year maturities fetching near 1.84%, one of the most attractive yields anywhere in the world. This world-wide low interest rate phenomenon has persisted much longer than anyone thought possible. That is the current state of affairs.
If we are not careful, we can be lulled into an assumption that today’s interest rate environment will persists indefinitely. As we look at where we are headed over the next year, the answer is that interest rates are likely to rise – albeit at a very slow pace. Based on today’s data, we might see Fed officials raise short-term rates twice in the upcoming year. Perhaps once in July and perhaps again in January. If growth starts to slow, or if there are geo-political events that produce negative risks to markets, they could go even slower than that. Our thesis remains that interest rates will rise at an extremely slow pace in the near term. There is even a new philosophy gaining some traction with officials- most notably with James Bullard. The traditional thinking has been the lower rates are, the more this stimulates the economy. Mr. Bullard proposes that there is a law of diminishing return on the downside – that is if you go too low, it actually paralyzes economic activity rather than stimulating it, because it sends the message that the economy is in a really bad place. Bullard proposes that confidence actually decreases once rates go below a certain level. If his perspective gains traction with the voting members of the Fed, this could be another reason why rates are likely to head up, rather than stay flat or go back down.
What about beyond a year? The pace will probably remain a slow increase. A normal Fed Funds short-term interest rate is elusive. Will it be 3%? Will it be 5%? No one knows. It is probably on the lower side of the historical average, because current day central bankers use a wider variety of tools to control the money supply that were not available in the 80’s when interest rates were extremely high. However, with each year that passes, the pace of rate increases may also accelerate with inflation gaining traction. Is the hyper-inflation of the 80’s possible? Certainly. Anything is possible in a free-market economy. Is it likely? Probably not, primarily because of the new tools at central banker’s disposal. There is also the possibility of another recession somewhere down the road. The Fed will want to get rates high enough that they will have room to decrease should another recession appear 3-5 years down the road.
In summary, We will eventually get back to a more “normal” interest rate environment. The question is, what is that new normal? Probably lower than what we think of as “normal.”