Up or Down? – Interest Rates and the Fed

August 2, 2019 · Written By J. Stephen Lee

On Wednesday, July 31, the Federal Reserve Board Open Market Committee (FOMC) cut its benchmark lending rate by one-quarter of a percent to a new range of 2.0% – 2.25%.  A quarter of one percent does not seem like much to get excited over, but the action drew worldwide headlines and significant financial market reaction.  Why was this so important?

Interest rates set by central banks are at the core of global financial policy. Theoretically, the lower the rate, the “easier” monetary policy is — meaning that lending rates and the cost of business capital are at low levels that are stimulative, helping drive spending by consumers and corporations, and thus, overall economic growth. Conversely, in times of strong growth, a central bank will then raise — or “tighten” — lending rates to make certain an economy does not overheat and a dreaded high inflation cycle set in.

Until this week, the last rate cut by the FOMC was December 16, 2008, as the Great Financial Crisis raged.  In the nearly 11 years since, rates have stayed at record low levels, inflation has hovered near 2%, and a slow but steady economic recovery has occurred in the U.S.  The current economic expansion, which began when the Financial Crisis ended in 2009, is now the longest on record.

In December 2015, after six years of recovery, the FOMC embarked on a rate hiking cycle, raising rates nine times, with the last hike in December of 2018.  Comments from the Fed have indicated a preference to raise rates even higher, seeking a return to pre-crisis levels.  So, a policy change from raising to lowering indeed does represent a sea change and calls into question the future path.

This change in rate policy is also important because the world looks to central banks to provide clarity and guidance — two factors that are hard to come by in many areas today. Until recently, the Fed was signaling sunny skies for the US, but now there are doubts.

Jay Powell, Chair of the Federal Reserve, and his colleagues do not have an easy task — there are many conflicting signals. On the positive side, US unemployment at 3.7% is near 50-year lows, the latest jobs report shows 164,000 jobs created in July, wage growth is occurring, and stocks have been rising.

But contrast that with global slowing in manufacturing and trade. The most recent Institute for Supply Management (ISM) manufacturing data was at its lowest level since 2011, as trade wars and tariffs have taken a clear toll.  New China tariffs announced by the administration this week further cloud the horizon — at $13 trillion of annual output, China is the world second largest economy.  So, a conflict between China and the US, the world’s largest economy ($21 trillion), causes significant jitters.  In addition, worldwide ultra-low rate policies mean that about 25% of all global bonds — approximately $14 trillion — carry negative yields, an astonishing “not in the playbook” willingness of bond-buyers to accept less money upon maturity of that bond than was paid for its purchase. This turns the conventional bond buying valuation completely on its head.  Not to mention the new, unpredictable UK Prime Minister, Boris Johnson, and a “hard” Brexit likelihood, as well as disruptive technology with unknown impacts, such as 5G.  Central bankers must feel like they are working in a dense fog with broken fog lights when trying to craft policies.

So, the financial world hangs on the actions and comments of not only the US Fed but also foreign central banks. Look for more volatility ahead, as the conflicting signals are likely to continue. It seems probable the low rate environment will persist — today’s linked global economies just do not permit one system to operate totally independent from another.

From a JFS perspective, the implications are clear — be certain that goals and risk tolerances are clearly understood and matched to portfolios, ensure that target portfolio balances are maintained, and strive to always keep open lines of communication with our clients. In uncertain times we focus on the certainties of careful planning and management.

On behalf of all my colleagues at JFS, we remain gratified by your continued confidence.