The Fed Raising Rates?

The Fed Raising Rates?
David Kotok
Cumberland Advisors, May 26, 2015

It’s not about when; it’s about the path to get there.

Suppose the Fed lifts rates on the short end of the yield curve by a quarter point in September. Or December. Will it really make a difference? Suppose the Fed’s short-term rate a year from now is 1%. Or 0.75%. Or 1.25%. Will it really make a difference?

And can (yes they can) or will (no they won’t) the Fed do this in a vacuum?

What happens if they raise rates without regard for or attention to the rest of the world?

Think about the fact that the European Central Bank will still be at negative rates. Japan will still be around zero. Non-euro, smaller economies such as Sweden, Switzerland, and Denmark will still be at negative rates. Countries like Portugal or Bulgaria will still be able to finance themselves at rates below those of the United States. The dollar will likely be in a longer-term upward trend against nearly all other currencies. At Cumberland, we already and strategically target the euro below 100 and the yen above 135.

So does it really make a difference whether the Federal Reserve’s target rate a year from now is 1%? Or something close?

The simple answer is NO!

What would make a difference is a robust recovery in the US. If that were to happen, the dollar would get even stronger, but the longer-term interest rate may rise due to stronger growth.

Or we could get a burst of inflation that takes the changes in the price level from under 2% toward the 3% level. Remember, this is the rate of change as a broad measure of prices, not a single price.

Is a burst of inflation likely? Maybe. How about a robust recovery where the growth rate accelerates to something close to 3–4% on a sustained basis? Could happen. But neither seems very likely today. Neither is supported by market based indicators.

Let’s go back to some very basic facts. The most enduring principle in the valuation of assets of all types is that the prospect of interest-rate changes matters. We live in a world of nominal rates. We can measure them every minute from live trading data.

We extract and estimate the rate of inflation, and the remainder is taken as the real rate. Over the longer term the real interest rate roughly matches the real growth rate. This makes sense intuitively and is supported by many serious studies.

So pick a real rate. Guess at an inflation rate. Combine them. Add a risk premium for being wrong, and you have an estimate of the nominal interest rate over a longer period of time. Also note that the longer term estimate is a theoretical continuum of all the short term rates in between now and the maturity of the longer term..

With low inflation and slow growth, low nominal rates are likely to be with us for a while. And if central banks take rates too high too fast, they will cause the real rate to be higher than it would otherwise be, and that distortion will slow growth.

The only real question is whether the world’s central banks have the ability to raise the inflation rate faster than it would otherwise change. They have been trying to do that. That question is unanswered. So far, the answer is NO! The central banks are now engaged in extreme measures, and, even so, the answer may continue to be no. In Japan it has been no for 20 years. In Europe the answer is uncertain but may still be NO!

In the US, the jury is still out on this question. But a jury (in this case the FOMC) that has not yet delivered a verdict. The FOMC is still a jury, and the jury continues to deliberate.

No one knows what the American inflation rate will be in a few years. We are all guessing. But we do know that it will take either very robust growth or accelerating inflation to get those rates a lot higher.

So, we conclude that low interest rates are likely to be with us for some additional number of years. And the path to higher rates is certainly likely to be slow and gradual. Fed Vice-Chair Stanley Fischer made that clear this weekend. Chair Yellen did, too.

David R. Kotok, Chairman and Chief Investment Officer, Cumberland Advisors