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  • Writer's pictureSteve Coker, CFP

Should We Fear the Fed?

After several months of relative calm and fairly steady increases, stock markets fell sharply Friday with the S&P 500 declining 2.45%. Most pundits blame Federal Reserve Bank of Boston President Eric Rosengren, known as one of the more accommodative Federal Reserve Governors, for spooking the market with comments that “a reasonable case can be made” for tightening monetary policy. His comments, made during a speech in Boston on September 9th, immediately increased expectations that the Fed could raise rates sooner rather than later. All eyes appear to be on the Fed as the market reacts to every word that the Federal Reserve puts out. Given the market response, I thought it would be appropriate to share some of Rosengren’s actual comments to put the Fed’s actions, and the market’s concern, into context.

The Federal Reserve is actually very transparent and posts much of their research and speeches online. You can see a recording of Rosengren’s speech on the Boston Fed’s website. Contrary to what many people believe, the rationale for increasing interest rates is that the economy is actually doing so well. In fact, Rosengren paints a fairly robust picture of the US economy. Here are a few of his key points:

  • While the US economy grew slower than expected in the first half of the year, one of the reasons was that companies reduced their inventories. Since inventory reductions are cyclical in nature this factor could actually help the US economy in the second half of the year.

  • Most forecasters expect 3rd quarter GDP to grow well above 2 percent. The Federal Reserve’s own forecasting model predicts 3rd quarter growth above 3 percent. Rosengren believes this economic strength could extend well into next year.

  • The US is approaching full employment with the unemployment rate at 4.9% and the economy continuing to show strong job creation. The economy created over 250,000 jobs in June and July. Even August’s 150,000 created jobs were well above the 100,000 jobs the economy needed to create to maintain the current employment rate.

  • Average hourly wage growth is actually trending up. The economy is strong enough now that wages are starting to grow. Wage growth is what we will need if we would like to see inflation start to increase.

  • Commercial real estate, and in particular apartments, are starting to show signs of overheating. Commercial real estate is highly volatile and is one of the sectors that are closely watched for signs of overheating.

  • Stock markets are trending up. Emerging markets are the canary in the coal mine for global growth. EM stock market increases imply that the emerging market economies are actually improving. In addition, despite earlier concerns with China’s economy and the Brexit vote, volatility is actually quite low. Markets show little evidence of ‘outsized’ risks

Given the positive nature of these comments, you may be wondering why the stock market reacted so negatively. Markets are simply concerned with policy error. The truth is that economic expansions do not die of old age, they die from ‘policy mistakes’, usually the Federal Reserve tightening too much and slowing down the economy to the point of recession. The Federal Reserve has the difficult job of trying to balance the conflicting goals of full employment and low inflation. As the economy starts to reach full employment the Fed uses higher interest rates as a tool to slow the economy and avoid high inflation. If the Fed raises interest rates too slowly then inflation will accelerate and they will be forced to take aggressive action. If the Fed raises rates too quickly then they risk stalling economic growth and tipping the economy into recession.

The positive comments from Rosengren are evidence that the Federal Reserve sees strong growth in the US economy and therefore the Fed may start to increase interest rates more quickly than previously thought. Does this mean the end of the stock market rally? Admittedly, much is riding on good policy decisions by the Federal Reserve. Historically, however, stock market rallies continue for approximately 2 years after the first interest rate rise by the Fed. Given the anticipation of slower than normal interest rate increases, this cycle could last even longer. Interest rate increases can, in a way, be seen as an endorsement of how well the economy is doing. We can expect more volatility in the coming months until the Fed’s policy becomes more clear but as long-term investors we don’t want to lose sight of the fact that the economy is doing well.

*The full text of Rosengren’s speech can be seen here.

**According to the CME Group, the futures market is pricing in a 24% probability that the Federal Reserve will raise interest rates in September, up from an only 18% chance the day before as seen here.

If you would like more background on how the Federal Reserve’s interest rate policy can impact the economy, we recommend this excellent video.

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