Federal Reserve in a Bind
There is only one reason why the Federal Reserve is taking a cautionary approach to interest rate hikes: the rest of the world. Janet Yellen, Federal Reserve chair, said recently that while U.S. economic growth is on track, the Fed was leaving its benchmark lending rate unchanged because of problems caused by the global economy. And until the global economy gets better, the Federal Reserve will need to take an even more dovish approach to future interest rate hikes.
Global Economy Thwarts U.S. Rate Hikes
Yellen didn’t really surprise anyone when she held the key lending rate target unchanged in March at 0.25% to 0.50%. She noted that while U.S. economic growth is (apparently) on track, it is being offset by global economic weakness.
As a result, she said U.S. central bankers need to “proceed cautiously” in raising interest rates because of the heightened risks to growth in China and pretty much the rest of the world. Further, the decline in oil prices will also have an adverse effect on the global economy.
While maintaining interest rates near record-low levels might seem like a safe bet right now, the fact of the matter is that in light of the adoption of negative interest rates from central banks around the world, the Fed’s stance seems downright hawkish.
The European Central Bank sent its rates further into negative territory when it cut its deposit rate to -0.4%. The Bank of Japan held its interest rate at -0.1% but the bank’s governor, Haruhiko Kuroda, told Japan’s parliament that there is room to further cut interest rates in an effort to prop up the lagging economy, possibly to as low as -0.5%. (Source: “Kuroda says BOJ has room to cut rates further,” Reuters, March 16, 2016.)
The Swiss central bank has, like the European Central Bank and the Bank of Japan, conceded that its polices are no longer effective and has a negative interest rate of -0.75%. Sweden’s central bank has a negative rate of -0.35%.
So far, roughly 25% of global gross domestic product (GDP) is in economies whose central banks have adopted negative interest rates.
Still, if U.S. unemployment remains under five percent and inflation continues to rise, the Federal Reserve may need to actually raise rates in June. On the other hand, there is enough data to show the Federal Reserve could reverse its rate hikes back down to zero.
Unemployment numbers may look good and inflation is on the rise, but U.S. GDP slowed to 1.4% in the fourth quarter and the Atlanta Fed now sees first-quarter GDP crawling in at 0.6%. (Source: “GDP Now,” Atlanta Federal Reserve web site, March 28, 2016.)
One Other Reasons Why It Might Be Good to Be Cautious
There is another reason why the Federal Reserve should be a little cautious when it comes to raising interest rates: the stock market.
We may be in a technical bull market, but it’s been a year since U.S. stocks have gone anywhere. Investors haven’t witnessed a new high on the S&P 500 in 10 months and earnings are circling the drain.
In the just completed fourth quarter, the blended earnings decline was -3.3%. This marks the first time the S&P 500 has reported three consecutive quarters of year-over-year declines in earnings since the three quarters beginning in 2009. (Source: “Earnings Insight,” FactSet, February 26, 2016.)
Earnings in the first quarter of 2016 are expected to decline by 8.7% year-over-year. This will represent the fourth consecutive quarter of declines and the longest losing streak since the fourth quarter of 2008 through to the third quarter of 2009. (Source: “Earnings Insight,” FactSet, March 18, 2016.)
Admittedly, the last thing the stock market needs is for the Federal Reserve to cut it some slack. After all, in the face of declining earnings and a fragile economy, the artificially low interest rate environment is responsible for the geriatric bull market and overvalued stocks.
But the Federal Reserve helped create the stock market bubble, so it needs to take some action in helping the last bastion of capitalism recalibrate itself. After all, rising interest rates will cut into profits that are already circling the drain.
That’s not the best outlook for the world’s biggest economy and one the rest of the world is hoping will drag it from the precipice of a global recession.