The Real Story Behind a Fed Rate Increase

Posted by Brad McMillan, CFA, CAIA, MAI

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This entry was posted on May 24, 2016 1:16:15 PM

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fed rate increaseAnother Federal Reserve official, Philadelphia Fed president Patrick Harker, has weighed in on rates, projecting two to three hikes over the rest of 2016, including a June increase. Much of the commentary on his statement and those of other Fed members has focused on the potential effects on the stock market—specifically, the risk that higher rates may pull the market down.

Will rate hikes sabotage the market?

This is a real risk and a real concern. Other things being equal, higher rates make the stream of earnings from a stock portfolio worth less in the present. Other things, however, are rarely equal. In this case, what matters is whether there are any positive big-picture effects that stand to offset the rate risk. As of today, there certainly are.

Let's keep one thing in mind: the reason for rate increases is that the economy is normalizing. Employment has grown strongly, wage growth has started to accelerate, and consumer spending has also picked up. Just this morning, new home sales shocked to the upside, increasing by 16.6 percent, well above even the highest level of expectations. New homes generate follow-on purchases of furniture, lawn mowers, and so forth. Consumption is clearly accelerating and will likely continue to do so, as it is well supported by incomes and saving.

This is particularly encouraging at this point in the cycle. Although companies have been increasing earnings, much of that has come from financial engineering, such as share buybacks, rather than organic growth in sales. It's unclear how much longer financial engineering can continue to grow earnings, making sales growth that much more important. Just in time, consumers look like they may be starting to spend again.

The real story behind a Fed rate increase isn’t the damage that might be done. Though a legitimate concern, that’s minor in the bigger picture. The real story is what the Fed's move would indicate about the economy as a whole.

Big picture, the economy is doing well

Given the minutes of its last meeting, the data since then, and the public comments by many Fed officials, the Fed clearly believes the economy is on track. Employment, one of its two mandates, is now at target levels, and inflation is well on the way. The Fed is now focused more on the risks of not acting than on the risks of acting.

This is a notable shift for a very scaredy-cat Fed. After the weakness of the past two quarters, the recent statements indicate a real sea change in members’ thinking—from expecting renewed disaster to expecting continued growth. Considering how hard it has been to get, this endorsement really matters.

Just as worry has fed on itself for the past several years, there is now real potential for a positive cycle to begin. Rising rates hurt borrowers, true, but they help savers. With rates still low, the help is likely to exceed the hurt. Homebuyers, who need mortgages, now have an incentive to act before rates increase even more, which should help the housing industry continue to grow.

Historically, the first part of a rate-increase cycle is associated with faster growth and a rising stock market, for exactly these reasons. The Fed may be initiating that growth cycle for the first time since the financial crisis. And in the end, that’s a good story.

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