We’ve gotten it into our heads that Fed Chair Janet Yellen is on her way down from the mountain top carrying stone tablets etched with the details of a rate hike. We don’t know exactly what form it will take, but let there be no doubt – the financial gods have spoken, so a rate hike there will be!
But it’s not that simple.
The Federal Open Market Committee (FOMC) is the group that determines monetary policy. This group must reach a consensus on policy changes before anything new can happen.
At the last meeting, the vote to keep rates the same was 9-to-1, with St. Louis Fed President Lacker dissenting.
In the vote to raise rates this week, it is possible that both Federal Reserve Board Governor Daniel Tarullo and Chicago Fed President Charles Evans will vote to keep rates where they are, making the tally 8-to-2 in favor of higher rates.
It’s still a consensus, but not unanimous. But what if the vote is closer, or even – dare we say it – what if it doesn’t carry?
At this point, barring a catastrophic event (think terrorism on a big scale) in the U.S. or Europe, or perhaps a terrible development in the Middle East, the Fed had better raise rates. If they don’t then they risk the one thing that keeps them in a job – credibility.
The Fed has many critics, including me. I don’t agree with some of their biggest policy moves, such as printing $4 trillion new dollars and holding real interest rates below zero for years.
I think their efforts have slowed the recovery in the U.S. and put a financial straitjacket on investors who deserve to be paid for putting their money at risk in fixed income.
But the Fed also has many supporters who rightly point out that our economy so far has not fallen off a cliff because of these interventions. They also note inflation has not run rampant (I’ll leave aside the $2.9 trillion in excess reserves here, as I’ve discussed that elsewhere).
Overall, the Fed still seems in control, and for the past month several members of the FOMC, including the Chair, have spent their time telling audiences that the time for higher rates has arrived.
Whether we like the decision or not, they have done everything but hold a pre-meeting vote to let us know it’s on the way. A reversal of this telegraphed position would mean that market participants have no basis for believing anything that FOMC members say. They’d only be able to look at actual policy moves, like changing rates, for clues on what lies ahead.
The result would be chaos.
Without knowing the direction of monetary policy – tightening with higher rates, or loosening with lower rates – no one knows how to manage their interest-rate sensitive positions.
Bankers don’t know if they should open the spigots today to lock in current rates, or hold off on lending because higher rates are around the corner. Corporations don’t know if it’s better to issue bonds at today’s rates or wait for tomorrow. Investors can’t determine if they should grab bonds available today or wait as well.
And that’s just for starters.
The world of currency is much bigger than the bond market, with trillions of dollars’ worth of currency trading hands every day.
Without an understanding of where interest rates are headed, currency traders, hedge funds, companies using currency for international trade settlements, and all other participants would be at a loss as to what comes next for their dollar holdings. Will they increase in value, or fall?
The resulting chaos would lead to financial self-preservation. Who would want to risk lending more money if rates might go up at the next Fed meeting?
If we can’t believe what they tell us, then this might be the case at every single meeting, which would cut down on the loans made by banks. They would hold their capital for another six weeks, waiting for a better rate environment.
Furthermore, currency traders and trade settlement financiers would likely pare their U.S. dollar holdings, since the currency would lose a bit of its stability.
Simply not raising rates at one Fed meeting wouldn’t kill the dollar by any stretch, but it would definitely put a nick in the armor. The dollar would fall against other currencies, and then be much more volatile leading up to future Fed meetings. While the cheaper dollar might help U.S. exports in the short run, the volatility would harm all dollar holders over time.
Apart from all this, I expect the Fed to raise rates this week in response to higher inflation on the horizon, and the desire to have at least one rate hike in the bag before the next downturn.
But more importantly, there is quite a case to be made that at this point, after everything they’ve said, the Fed must raise rates. They’ve got a reputation to protect.
All the commotion aside, we have a number of trading services that respond to short-term fluctuations in the market. But Lance’s Treasury Profits Accelerator most directly correlates with movements in interest rates. If you’re wondering how to position your portfolio for this event, you may want to take a look.
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