The story coming into the Yellen Fed was that Janet was a monetary dove, that she wasn’t up to the task of pulling back the stimulus, that she was going to keep pushing money into the system until things collapsed, that she was a loose woman who would lead the monetary system to perdition. All very 19th century—and, as it turns out, all wrong.
I said as much back in early February, pointing out that Yellen has been on the side of raising rates more than many of her colleagues and that, in fact, when she did come out as a dove, she turned out to be right. I thought there was a chance for the Fed to be more hawkish than most expected, to tighten further faster, and that Yellen was quite likely to lead that charge.
Yesterday, when exactly that scenario seemed to be playing out, markets took fright. Although the actual Fed statement was pretty much in line with expectations—the unemployment rate target was dropped, and the statement emphasized that rates would remain low for a long time—there were several indications that the Fed has started to plan for rate hikes. The notion of an actual time frame, as opposed to a “someday,” brought stock markets down even as interest rates ticked up significantly.
Evidence for sooner rather than the (expected) later included the higher interest rates in the official Fed projections, as well as what was probably an unintended comment during Yellen’s Q&A period, when she said that the “sometime” language for interest rate increases after the end of QE might really mean about six months—less than had been expected.
Despite the immediate market reaction, which has been largely reversed this morning, I would argue that the Fed is doing the right thing, and that this can actually be beneficial for both the economy and the stock market.
I have two main reasons for this. First, the Fed is saying it will not allow inflation to get out of control. One of the concerns has been that the Fed would stay too loose for too long, letting inflation out of the bag. The rising expectations in the official numbers, and the shorter-than-expected time frame revealed in Yellen’s comment, show that, far from being committed to unlimited stimulus, a plan to move back to normality is very much present. Lower inflation, over time, would mean lower rates—which would be good for the economy, despite the immediate impact.
Second, while there is a widespread impression that rising rates are bad for the market, that is not true. Rising rates below around 5 percent typically result in a rising stock market, not a falling one. It’s only when rates get above about 5 percent that they become a negative, as can be seen in the following chart from J.P. Morgan.
The reason for this is that around 5 percent has generally been the normal level for decades. If rates are below 5 percent, an increase is a return to normal, and stocks respond well. Conversely, if rates are above 5 percent, increases move away from normal, and stocks do not do well. Right now, as rates increase, we’re moving back to normal, which should cheer up the market.
The growing normalization of interest rates and monetary policy should be welcomed. I remain convinced, even now, that the risk is on the side of a faster normalization than the market now expects, which could result in more turbulence. If I’m right, though, the overall effects could be positive in the long run.