Why Did the Fed Decide Not to Raise Interest Rates?

While the Fed admitted that employment and inflation levels were approaching its goals, it worried that slower international economic activity would depress U.S. growth rates

Robert Johnson, CFA 21 September, 2015 | 10:54AM
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The Fed opted to kick the can down the road a bit, and decided not to raise rates at its September meeting. That was what about 75% of market participants had anticipated. While the Fed admitted that employment and inflation levels were approaching its goals, it worried that slower international economic activity would potentially depress U.S. growth rates and employment while a strong dollar was likely to keep inflation lower for longer.

It also had some concerns that the unemployment rate might not be the optimal metric for the labor market given a lower labor market participation rate and a continued high rate of part-time employees who want to be working full time. Given the uncertainty, it didn't feel an imminent need to raise rates. On the other hand, 13 of 17 governors thought that rates would be raised in 2015, hardly reassuring for those who want low rates indefinitely.

Plus, their longer-range forecasts show rate increases over the next year, albeit at a pace that is well below normal cyclical patterns. Current Fed governor forecasts have the Fed Funds moving up from 0.12% currently to just 1.4% by the end of 2016, slowly working its way to 3.4% by the end of 2018. In total that is just barely over a 3% increase over more than three years. The relatively slow pace and small size of the total increase are all well below history.

For some perspective, the last big set of Fed increases was in the early 2000s. Then, rates moved up from 1% to over 5% in just about two years. And that was one of the more modest bouts of Fed rate increases. However, those governors could be wrong in their forecasts, as they often are.

Interestingly, the Fed modestly increased its economic forecast for 2015 and lowered its forecasts for 2016 and beyond. Overall its forecast is now more in line with our thinking of 2.0%-2.5% real GDP growth as far as the eye can see. Although it raised the 2015 forecast from 1.9% to 2.1%, that forecast looks way too low to us as it implies second-half growth of just a smidge over 2%. Our forecast is for very close to 3% growth in the back half of the year.

Given what we have all seen so far in the third quarter – strong autos, improved retail sales and housing – 3% growth or so in the third quarter is a real possibility. That would mean the Fed is expecting the bottom to fall out in the fourth quarter with GDP growth of just 1% or so. It could happen with an external shock, but that just doesn't seem to be the most likely case to us. If the Fed believes its own forecasts of strong deceleration, it most likely would not be raising rates at all in 2015.

The Fed also reduced its core inflation forecast and its unemployment rate forecast modestly in 2016 and beyond. Meanwhile, it tweaked 2014 inflation slightly higher. Also, the Fed went out of its way to say it would continue to buy more bonds to replace all of the bonds that it held that were maturing on its $4 trillion balance sheet. Stopping that rollover process would have been a backdoor method of tightening monetary policy.

As we have said, we really wish the Fed would just get on with it and end the circus atmosphere surrounding each meeting. Rumors were that traders were passing around Yellen's horoscope prior to the meeting. Investors and traders appear to be more interested in placing short-term bets in a racetrack-like atmosphere than considering the long-term trends.

A quarter percent hike is highly unlikely to have any impact whatsoever on the real economy. And it gives the Fed a little more wiggle room to eventually lower rates in case a slowdown develops. A small move soon would also have tested the waters a bit in terms of markets. We are adamant that the first rate increases or even the governors' expectation of a 1% hike in 2016 would have little impact on the real economy. The small increases would be barely visible against double-digit credit card rates or even auto loans; longer-term rates that drive mortgage rates are already up significantly.

What we don't know is how much equity markets would be affected by the higher rates. Furthermore, all of the dawdling and on-again off-again rate increases certainly aren't helping business confidence. If the Fed is so scared it won't raise rates even a tiny amount on a silly low base rate, why should businesses feel like they should take a chance and invest aggressively?

Especially when the Fed, with all of its statisticians, can't get seem to get its forecasts right, and the Fed chairman talks of continuous uncertainty. The dawdling certainly hasn't helped the U.S. stock market either, which is now down close to 7% in 2015. Again, we caution readers that watching the real economy is far more productive than watching the Fed Circus every month. On that front, the news is still good. In fact, we still believe the US economy in 2015 could very modestly exceed our 2%-2.5% long-term  growth forecast.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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Robert Johnson, CFA  is director of economic analysis with Morningstar.

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