Fed Open Mouth Operations Are No Substitute for Interest Rate Hikes
As the U.S. enters the final 100 days of the presidential campaign, the Federal Reserve has not yet raised interest rates in 2016. This is quite remarkable since Fed Chair Janet Yellen and Fed officials have been promising rate hikes for years. Interest rates have been raised just once, a quarter point in December 2015, in over ten years. Even more remarkable is the lack of inaction in light of the official narrative that U.S. has a solid and robust job market (e.g. unemployment just 4.9%!, lowest initial jobless claims since 1973!) that augurs an acceleration of economic growth in the second half of this year. With the economy supposedly gaining momentum, a few rate hikes would seem to be in order.
Instead of rate hikes, however, we have been getting talk about rate hikes from Fed officials.
The Fed rate hike talk has a long history. In 2014, as the Fed was winding down its third round of quantitative easing, it was preparing the markets for a gradual “normalization of interest rates”. Fed officials made statements indicating that rate hikes were coming and that the pace of those rate hikes would be gradual. Market expectations were set in 2014 that within two or three years, U.S. interest rates would have undergone six-eight rate hikes and that interest rates would be at or around 2% by the end of 2016.
2015 came and nearly went without an interest rate hike. The Fed managed to sneak in a quarter point rate hike in December 2015. The Fed then conditioned the markets to believe, now that it had finally raised interest rates, further rate hikes would be forthcoming. The pace would be gradual, perhaps four rate hikes in 2016.
Instead of rate hikes in 2016, we got talk about rate hikes, lots of talk.
In the spring of 2016, the Fed changed it forward guidance on rate hike expectations. Instead of four rate hikes in 2016, markets should perhaps expect just two. By late spring, market participants began to doubt whether the Fed would raise rates at all in 2016. The Dollar Index had fallen all year from a high of about 100 down to around 94. In May, market complacency regarding rate hikes sent the various regional Fed Presidents into full rate hike talk mode. Fed Open Mouth Operations began as one after another, more than a half a dozen Fed presidents, warned the markets not to discount the possibility of rate hikes in 2016. Rate hikes, they insisted, were coming and indeed they might start as soon as June. The Fed managed to talk the market into believing it was still on a gradual rate hike path and the Dollar Index rebounded.
The Fed’s June and July’s meeting came and went without a rate hike. The anticipation of the Brexit vote in June and the aftermath of Brexit got part of the blame for no rate hikes during the Fed’s summer meetings.
Five Fed meetings (January, March, April, June and July) have passed in 2016 without a rate hike. Just three meetings remain (September, November and December). Until earlier this week, a rate hike(s) in 2016 seemed improbable.
Fed Open Mouth Operations Recommenced This Week
On Monday night, the Dollar Index dropped a full dollar. Gold and silver spiked. Then, as if on cue, Fed Presidents returned to Open Mouth Operations to remind the markets that the Fed could raise rates at least once, if not twice, in 2016. The first of the two threatened rate hikes might come as soon as September. New York Fed President William Dudley cited “the tightening labor market” as the rational for his renewed interest in talking about raising interest rates as soon as the Fed’s September meeting. Atlanta Fed President Lockhart boldly declared:
“I would not rule out September. If the meeting were today, I think the economic data would justify a serious discussion” as to whether to raise rates now. It’s conceivable we could have two rate increases this year.”
The possibility of just one rate hike in 2016 might have been dismissed by market participants, but TWO seemed to grab the attention of the markets. Two Fed Presidents mentioning that a rate hike was possible in September and perhaps two were coming this year was enough to temporarily stop the slide in the dollar and halt the rise of gold and silver.
With all other major central banks cutting rates close to zero or into negative territory, the Fed wants market participants to believe that when it talks about interest rates it means that it will raise interest rates even though it never does. We’ve seen and heard this movie before, but we don’t know how it ends or how long the reruns can play.
This article by BGASC is not, and should not be regarded as, investment advice or as a recommendation regarding any particular course of action.