The end of the Federal Reserve’s bond-buying program in October has led to expectations for the beginning of a series of short-term interest rate hikes around the middle of 2015. But we’re not there yet.
Recent economic data have largely come in strong, with gross domestic product (GDP) expanding at a 5.0% clip in the third quarter, its fastest pace in 11 years. GDP has risen more than 3% in four out of the past five quarters, as well, with the exception being the weather-dampened first quarter of 2014. A similar success prevails in the labor market, where more than 200,000 jobs have been created for 10 months in a row and the unemployment rate has fallen to 5.8% from 7.0% a year earlier.
Nevertheless, the Federal Reserve remains skittish or, in its latest parlance, patient, about raising interest rates. The slowness of the central bank to increase its short-term interest rate targets stems from several factors, including a desire to see growth strongly embedded in the economy after the sharp tumble business conditions took during the last recession. But the good news on the economy and the job market suggests that the expansion is firmly on track. The last piece of the puzzle would seem to be wage growth, an element to the recovery that has been lacking until only very recently. And, according to the Fed, surveys by government bodies point to better pay ahead for workers in 2015.
Clearly, there is mounting evidence that the time is right to jettison the extreme monetary stimulus measures adopted by the Fed during the height of the last downturn and move toward a neutral stance. But to many observers it sometimes seems as if the central bank is looking for reasons to delay implementing plans to slow the economy’s growth. Besides the labor market, the Fed apparently remains concerned about the potential for deflation, as well as the possibility of weak business conditions abroad spreading to these shores.
It is a bit curious that deflation has become a worry in that, for many years, inflation was the primary fear of central bankers. True, Japan has experienced on-and-off deflationary conditions since its heyday in the 1980s, but its economy also has been sputtering for years. There is some risk now that, with oil prices having fallen, deflation might take hold, or that disinflationary (lower inflation) trends might make the Fed once again put its stated goal of normalizing interest rates on the back burner.
Regarding overseas weakness coming home to roost in the United States, there doesn’t seem much the Fed can do about that directly, except to keep stoking the economic engine here to minimize any negative effects. But if Europe manages to muddle through its difficulties and China engineers a soft landing to its own set of business conditions, the backdrop might be as good as it gets to allow the Fed to finally get rid of the zero-interest rate policy adopted as an emergency measures six years ago. That is assuming the labor market continues to experience material improvement and wage growth perks up.
In the end, the Federal Reserve policymakers will, hopefully, be able to use successful transitions of the past as a blueprint. That would entail raising interest rates to tap the economy’s brakes and slow the decline in the unemployment rate. The time for such a move is nearing, if the Fed does not want to overshoot the so-called natural rate of unemployment of around 5.5%, after which policy measures designed to slow the economy become less effective.
Investors looking to capitalize on the pending shift to higher interest rates might take a look at lenders, such as PNC Financial (PNC) or insurers, including MetLife (MET) that stand to benefit from such an environment.
At the time of this article, the author did not have positions in any of the companies mentioned.
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