Friday, September 18, 2015

The Fed Is In A Pretty Tight Corner On Future Of Rates

So the Fed did not raise rates yesterday. To some this seemed to be a surprise; however, as we noted in our post a few days prior to the announcement we believed global economic factors could play a part in the Fed's rate decision. In fact, Janet Yellen cited issues in markets outside the U.S. as one reason for not moving on rates. Additionally, inflation in the U.S. remains well below the Fed's 2% target rate. Possibly the biggest surprise out of the meeting was the fact one Fed member believes the Fed needs to move to a negative interest rate position.

In our view the Fed has waited too long to move interest rates higher. The result is the Fed is now in a position where their next move, not necessarily in the next six months, would be lowering rates given where both the U.S. and global economies are in their respective business cycles. The comment on negative interest rates by one Fed member was likely not made without the blessing of Yellen in advance of the meeting. Because the Fed may believe they missed the opportunity to raise rates, the negative interest rate comment is a way to telegraph to the market they have a tool to stimulate if necessary in spite of the current zero interest rate level.

From The Blog of HORAN Capital Advisors

The other factor at play in the Fed's decision maybe the interplay of higher rates and currency exchange rates. It is clear that China and Russia have been selling Treasuries in an effort to weaken support their own currencies.  (updated: 8:30pm)

From The Blog of HORAN Capital Advisors
Source: zerohedge

This being the case, who is left to fund the government deficit? It is estimated that non-U.S. investors purchase about $300 billion in Treasury securities a year. If these foreign buyers are now sellers, that leaves the Fed as the last resort to fund the U.S.'s deficit spending, i.e., continued monetization of the debt. The deficit is now running at about $500 billion.

From The Blog of HORAN Capital Advisors

The last factor at play with the deficit and higher rates is the economic phenomenon of "crowding out." The "crowding out" issue is one that is much debated. In simplifying the crowding out effect, it pertains to the fact, if the government is issuing debt to to the public sector to fund the deficit, these private dollars are not available to corporate borrowers to fund expansionary projects. Crowding out tends to turn into crowding in when the economy is in recession and where employment is not at full employment levels. So today unemployment data would suggest the economy is at a near full employment level. The full employment level is debatable too given the low level of the participation rate. In the end though, higher interest rates will take more funds out of the private sector by increasing the budget deficit (interest on the government debt), higher rates would likely act to strengthen the U.S. Dollar resulting in more selling of Treasuries by foreign holders and the higher rates would put pressure on multinational company sales as the stronger Dollar makes exports in Dollars more expensive to foreign buyers.

From The Blog of HORAN Capital Advisors

So in the end the Fed seems to be boxed into a pretty tight corner. They have waited too long to raise rates and the business cycle may suggest the next rate move would be a decrease. With respect to the government sector, deficit spending may now be a drag on the economy and the deficit is crowding out growth in the private sector and higher rates will exacerbate this issue.  The lower level of economic growth since the end of the financial crisis may be evidence of this. To fund the deficit, does the Fed believe they need to initiate a QE4 or institute a negative interest rate policy. I hope not; however, it may mean the Fed maintains its Zero Interest Rate Policy (ZIRP) for a much longer time period.

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