At the beginning of 2008, the Federal Funds rate stood at 4.25 percent Ã¢â‚¬â€œ by the first week of March, the rate had been reduced to 3.0 percent, followed by another full-point reduction a few months later. But then, on December 16th, the Federal Reserve took us to a place we have never been before with a record low target rate of between zero and 0.25 percent. Obviously, extraordinary times call for extraordinary actions; but while the Fed demonstrated an unprecedented willingness to slash interest rates as the depth of the recession became known, will the Fed be just as quick to raise interest rates should indicators confirm a recovery is definitely in the works?
The answer to that question lies in whether the Ã¢â‚¬Å“hawksÃ¢â‚¬Â or the Ã¢â‚¬Å“dovesÃ¢â‚¬Â end up ruling the Federal Open Market Committee (FOMC) in the new year. With that in mind, I offer this brief review of the public record and recent pronouncements of some influential FOMC members, as well as a look at the economic conditions that will likely affect interest rate decisions in the coming year.
Interest Rate Hawk or Dove?
The term interest rate Ã¢â‚¬Å“doveÃ¢â‚¬Â describes those that advocate keeping interest rates low for an extended period of time. The current doves point to JapanÃ¢â‚¬â„¢s experience in the early 1990s as a reason to be Ã¢â‚¬â€œ shall we say, Ã¢â‚¬Å“cautiousÃ¢â‚¬Â Ã¢â‚¬â€œ with respect to the raising of rates so early into a recovery. The doves claims that the Bank of Japan erred when it raised rates soon after emerging from a severe recession, and was solely responsible for tipping the economy back into recession, thereby ushering in JapanÃ¢â‚¬â„¢s Ã¢â‚¬Å“lost decadeÃ¢â‚¬Â.
On the other side of the argument, we have the interest rate Ã¢â‚¬Å“hawksÃ¢â‚¬Â, who maintain that meaningful rate increases are needed once the economy shows signs of recovery in order to prevent inflation from gaining a foothold. The hawks even go so far as to say that the billions provided through the governmentÃ¢â‚¬â„¢s stimulus spending program makes the likelihood of inflation all the more certain, making it especially critical that the Fed be prepared to implement an aggressive interest rate policy.
Current Interest Rate OutlookThe interest rate guessing game is a preoccupation with all currency traders as interest rates are one of the most influential factors affecting exchange rates between two currencies. Looking ahead to what 2010 could bring for us interest rate watchers, many questions abound regarding Ã¢â‚¬Å“ifÃ¢â‚¬Â and Ã¢â‚¬Å“whenÃ¢â‚¬Â a rate increase is likely. Despite these lingering questions however, there is one fact for which we can be certain Ã¢â‚¬â€œ there is only one direction interest rates can go and that is up! We may not know by how much rates will increase, and we certainly donÃ¢â‚¬â„¢t know when they will increase, but rest assured, increase they will.
The easing of interest rates was just one aspect of the Federal ReserveÃ¢â‚¬â„¢s battle plan for dealing with the recession; the Fed also participated in the direct buying of so-called Ã¢â‚¬Å“bad assetsÃ¢â‚¬Â in order to remove dodgy assets from the balance sheets of the nationÃ¢â‚¬â„¢s lending institutions. However, the mid-August FOMC statement offered the first hint that the Committee was planning to wind down the spending program:
The Federal Reserve will purchase a total of up to $1.25 trillion of agency mortgage-backed securities and up to $200 billion of agency debt by the end of the year. In addition, the Federal Reserve is in the process of buying $300 billion of Treasury securities. To promote a smooth transition in markets as these purchases of Treasury securities are completed, the Committee has decided to gradually slow the pace of these transactions and anticipates that the full amount will be purchased by the end of October.
Reading between the lines, it appears the FOMC is Ã¢â‚¬Å“hedgingÃ¢â‚¬Â its bets by floating the idea that the economy has recovered sufficiently to warrant the reduction of direct spending, but not necessarily enough to enter into a discussion on interest rates. Without a doubt, the message is yes, things are slowly improving, but as to the strength and sustainability of the recovery, doubt still remains.
And there is good reason for this doubt; as I write this piece, I have just seen the Non-Farm payroll numbers for October and on the jobs front at least, the outlook is still grim. Another 190,000 jobs were lost in September and for the first time since 1983, the unemployment rate topped 10 percent, and is currently at 10.2 percent overall. This is an increase of almost 4 percent in the past twelve months.
Economic Recovery and Unemployment
The interest rate hawks believe that if the Fed keeps interest rates too low, for too long, there is a very real risk of inflation similar to the vicious bout of inflation those around during the early 1970s surely recall with great trepidation. Back then, it took a new man at the Federal Reserve Ã¢â‚¬â€œ Paul Volker Ã¢â‚¬â€œ to step forward and fight back inflation with a series of brutal and painful measures culminating in the setting of interest rates in the 20 percent range. Those favoring rate hikes in the short term, say they want to ensure we donÃ¢â‚¬â„¢t have a repeat performance.
While the hawks invoke memories of the 1970s, the doves lobby against interest rate hikes by pointing out that raising interest rates would surely put an end to the early stages of the recovery. The doves also point to the excess slack in the system Ã¢â‚¬â€œ that is, the high number of unemployed workers and lower levels of production Ã¢â‚¬â€œ as proof that the economy requires continued nurturing for the foreseeable future.
The hawks acknowledge the existence of the Ã¢â‚¬Å“slackÃ¢â‚¬Â in the economy right now, but they argue it is actually further evidence for why the Fed needs to start preparing for inflation now. According to the hawks, if manufacturers expect inflation sooner rather than later Ã¢â‚¬â€œ and if consumers also believe that higher inflation is inevitable Ã¢â‚¬â€œ manufacturers will start building an inflation increase into their prices and consumers will demand higher wages to offset price increases. This Ã¢â‚¬â€œ according to the hawks Ã¢â‚¬â€œ has the makings of an inflation spiral and requires a Ã¢â‚¬Å“signalÃ¢â‚¬Â now to demonstrate to the markets that the Fed will not allow inflation to gain a foothold even as the recovery strengthens.
The main difficulty with timing interest rate increases in the wake of a recession and subsequent recovery, is that a recovery in employment invariably lags an economic recovery. This is because it takes time for growth in the economy to translate into new jobs, and companies need several months of positive growth before they can start the hiring process. However, the interest rate hawks believe that now that the economy is expanding, some tough questions need to be immediately asked of officials, not the least of which is a new interest rate policy.
Speaking of employment, I recently heard the term Ã¢â‚¬Å“jobless recoveryÃ¢â‚¬Â for the first time and I must say, I find it immensely confusing. It seems to me that it is quite impossible for an economy continuing to shed jobs to experience significant growth, but this is the exact scenario that some members of the Fed are warning us about.
Consider comments made in October by Richmond Federal Reserve Bank President Ã¢â‚¬â€œ and self-avowed interest rate hawk Ã¢â‚¬â€œ Jeffery Lacker who made the following statement in a recent interview with Bloomberg:
I am going to be looking for when growth reestablishes itself firmly enough that it is clear real interest rates need to rise. I think the growth outlook, particularly the consumer spending outlook, are more fundamental than labor-market conditions.Ã¢â‚¬Â
- Bloomberg interview – October 1st, 2009
I understand what Lacker is saying, but until jobs return, I donÃ¢â‚¬â„¢t see consumer spending rebounding to the point that the economy makes significant gains. Granted there could be limited growth before then, but certainly nothing that could be described as inflationary. This reasoning falls in line with recent comments from Federal Reserve Chairman, Ben Bernanke:
We have a very long haul here. Unemployment is going to stay high for quite a while, and so it’s not going to feel really like a strong economy.
- Federal Reserve Chairman Ben Bernanke in testimony to the House Financial Service Committee Ã¢â‚¬â€œ July 21st, 2009
I feel that Bernanke is probably reading the tea leaves correctly Ã¢â‚¬â€œ especially his thoughts on employment, and I believe this will mean that we should expect interest rates to remain at or very near their current levels for most of next year.
For me, the more interesting question is how quickly will rates increase once the interest rate seal is broken? Over the past two and-a-half years, we have witnessed a record race to zero, but will authorities implement interest rate increases with the same zeal with which they lowered them? Here is an interesting comment from FOMC Board Member Kevin Warsh that sheds some light on the question:
Ultimately, when the decision is made to remove policy accommodation further, prudent risk management may prescribe that it be accomplished with greater swiftness than is modern central bank custom. The Federal Reserve acted preemptively in providing monetary stimulus, especially in early 2008 when the economy appeared on an uneven, uncertain trajectory.
If the economy were to turn up smartly and durably, policy might need to be unwound with the resolve equal to that in the accommodation phase. That is, the speed and force of the action ahead may bear some corresponding symmetry to the path that preceded it.
- Kevin M. Warsh – 12th Annual International Banking Conference, Chicago, Illinois Ã¢â‚¬â€œ September 25, 2009
Bernanke and the Final Word on 2010 Interest RatesFor the most part, Federal Reserve Chairman Ben Bernanke has managed to defy an interest rate label, but if one were forced to place him in either the hawk or dove camp, most analysts would categorize Big Ben as a mild hawk. However, nothing like a financial crisis to change oneÃ¢â‚¬â„¢s outlook, and there is no question that since the Fed began its program of slashing interest rates to counter weaker consumer spending, Bernanke has flocked with the doves. But with the beginnings of a fragile recovery in the works, where will Bernanke land now?
During the summer of 2009, Bernanke immortalized the phrase Ã¢â‚¬Å“green shoots of recoveryÃ¢â‚¬Â to describe the fragile recovery he believed was then under way in the US economy. Nevertheless, he did take every opportunity to suggest that the economy would remain anemic for some time and recovery would occur at a much slower pace than we have experienced in the past, noting also that unemployment would continue to climb and remain elevated well into the new year.
Ã¢â‚¬Å“Most forecasters including the Fed are currently looking at growth in 2010, but not growth so rapid as to substantially lower the unemployment rate,Ã¢â‚¬Â Bernanke told the House Financial Services Committee on October 1st. Even with 3 percent annual growth, unemployment would Ã¢â‚¬Å“still probably be above 9 percent by the end of 2010.Ã¢â‚¬Â
Bernanke understands that as the Federal Reserve Chairman, he must maintain a positive Ã¢â‚¬Å“stay the courseÃ¢â‚¬Â type message, yet he must also be realistic. The Fed is well aware of the fact that growth is still very weak and the expectation is that it shall remain so for some time yet; as a result, we can also expect interest rates to remain stable.
But what about the US dollar? The recent and prolonged slide of the once mighty greenback against most of the other major currencies is surely due in part to the FedÃ¢â‚¬â„¢s near-zero interest rate policy. This has led to a resurgence of the carry trade, only this time, investors are selling dollars to chase better returns by buying higher yielding currencies such as the Australian dollar. This is cold comfort alas, for those holding open US dollar positions, or for those buying foreign goods that are now more expensive because of the falling greenback, and calls for the Fed to do more to prop-up the dollar are growing louder.
For these unfortunates, I hate to be the bearer of bad news, but protecting the value of the dollar is not one of the FedÃ¢â‚¬â„¢s mandated responsibilities. Yes, yes Ã¢â‚¬â€œ I know that the FedÃ¢â‚¬â„¢s actions often affect the value of the dollar, but the legislated duties of the Federal Reserve fall into two basic tasks; ensure full employment and maintain price stability. Certainly the value of the dollar impacts employment and prices, but the fact of the matter is that if the Fed were forced to decide between a policy that helps them meet their mandated objective of full employment or a policy that supports the dollar, IÃ¢â‚¬â„¢m here to tell you the policy for employment will win every time.
Bernanke did acknowledge the sad state of the greenback on November 16th when he addressed the Economic Club of New York. In his discussion, he noted that the Fed remains Ã¢â‚¬Å“attentive to the implications of changes in the value of the dollarÃ¢â‚¬Â, and promised that the Fed will continue to Ã¢â‚¬Å“monitor these developments closelyÃ¢â‚¬Â Ã¢â‚¬â€œ however, the Chairman declined to offer a specific game plan to reverse the dollarÃ¢â‚¬â„¢s downwards trend. Compare this language to the tone with which he has addressed the issue of unemployment and the need for low interest rates and I think it should be clear as to BernankeÃ¢â‚¬â„¢s priorities.
Given all this, what conclusions can we draw for the direction of interest rates for 2010? I believe that the evidence strongly suggests that rates will remain at Ã¢â‚¬â€œ or very near Ã¢â‚¬â€œ the present level. I say this because the Federal Reserve has made it a priority to ensure that the timid recovery is supported and allowed to become firmly established before any real thought is given to raising lending rates.
Unfortunately, a continuation of the current interest rate policy could very well come at the expense of the dollar which will likely remain weak as long as the Fed resists the temptation to return to rate increases. The continued availability of cheap credit is crucial to a meaningful recovery and the Fed is loathe to make borrowing more expensive for gun-shy consumers and businesses still reeling from two years of mounting losses and shrinking markets.
Secondly, as the recovery becomes more robust and growth expands, jobs will slowly return to the economy. Bernanke has reiterated time and time again that unemployment will likely continue to exceed 10 percent until the end of 2010, adding further to the argument that there is little chance for an increase in interest rates before then. If you question this, then I urge you to re-read some of BernankeÃ¢â‚¬â„¢s comments included in this article.
Thirdly, as consumers and businesses increase spending, and as more people return to work, there is potential for inflation and price increases, but this is at least a full year away. This is also when things could get interesting in a hurry. While I believe the current interest rate hawks on the FOMC will remain in the background for now, once growth approaches the inflationary level of 2 percent, I expect there will be mounting pressure within the FOMC for rate hikes. Depending on the strength of the recovery, we could well see a series of hikes mimicking the rate and depth of the cuts we saw during the worst of the recession.