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Why the Fed may not raise interest rates until late 2015

The Federal Reserve has signaled that wage growth could be a factor in the timing of interest rate hikes.

The Federal Reserve has signaled that wage growth could be a factor in the timing of interest rate hikes.

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From the pages of In Business magazine.

Having reached the point of diminishing returns, the unprecedented bond-buying program associated with the Federal Reserve’s quantitative easing has finally ended, with a whopping $4.5 trillion on the Fed’s balance sheet.

The nation’s official unemployment rate has dipped to 5.8%, and the U.S. economy has averaged a healthy 222,000 new jobs per month over the past year.

The economy has also experienced two consecutive quarters of strong economic growth, including 4.2% in the second quarter, and inflation remains low.

“Right now, we’re all paying 4% for money, or 3.9% or some ridiculous number that we didn’t dream of ever paying. We don’t model those.” — Eric Schwartz, president, Sara Investment Real Estate

So why, even as it announced the end of its bond-buying program, is the Federal Reserve still sending hesitant signals about when it will begin raising interest rates?

Based on previous Fed guidance, most observers assumed the Fed would pull the rate trigger in mid-2015, but after announcing the end of its bond-buying program in late October, the Fed stuck to its “considerable time” guidance on the question of raising interest rates above their historic lows.

After the Fed met some of its benchmarks, including a 6% or lower unemployment rate, its thinking has become a bit more mysterious. “With any indicator they have given us, we reach those corridors and nothing happens, and they continue to delay,” noted financial advisor Nathan Brinkman, president of Triumph Wealth Management in Madison. “That’s the frustration among people who work in the economic and market worlds.”

Whatever the magic elixir, interest rates have been kept artificially low for an extended period of time, and some business executives would like the Fed to stop vacillating. “Right now, we’re all paying 4% for money, or 3.9%, or some ridiculous number that we didn’t dream of ever paying,” said Eric Schwartz, president of the Madison-based Sara Investment Real Estate. “We don’t model those. Good developers don’t model the project on that for the next 10 years. It’d be foolish. We all know it’s coming, so let’s get on with it.”

What’s the problem?

The federal funds rate is the primary interest rate that the Federal Open Market Committee, which consists of seven members of the Fed’s Board of Governors, uses to influence other interest rates in the economy. Changes in the federal funds rate affect bank borrowing costs, and also the returns offered on certificates of deposit, savings accounts, money market accounts, and other bank deposit products.

In addition, such changes dictate changes in The Wall Street Journal’s prime rate, which is the base index for most credit cards, home equity loans, auto loans, and business lines of credit. In fact, many small business loans are also indexed to the prime rate, which has remained at 3.25% since December of 2008 and will remain there for a while longer after the FOMC’s recent vote to keep the target range for the federal funds rate between 0% and 0.25%.

Fed Chair Janet Yellen may have provided a glimpse into her own thought process when she expressed concern about income inequality. Indeed, stagnant middle-class wages are the primary reason people have yet to “feel” an economic recovery that’s now in its fifth year.

Bittles, chief investment strategist for Robert W. Baird & Co., believes the critical measures include wage stagnation and the unemployment rate, which is a bit skewed because so many people have left the labor force, offering a false impression that labor markets are sound. “Now, there are a lot of jobs coming on-stream,” Bittles acknowledged, “but the problem is that there has been no wage growth, so middle-income households and low-income households are still suffering.”

Interviewed in late October, Bittles noted that wages went down two-tenths of a percent the previous month, but ideally they need to grow by about 3.5% to 4%. “They have been growing at about 2%, which is about the inflation rate,” he noted. “Real wages [wages adjusted for inflation] have not grown at all.”

The Fed’s inflation target is 2%, but over the past 12 months, the Consumer Price Index is up just 1.7%. Bittles noted inflation is typically a function of income, and if wages aren’t going up, it’s difficult to generate any sustained inflation. “So I think that’s the first thing the Fed is going to watch — wages,” he stated.

Craig Elder, senior fixed income research analyst for Baird, added that the Fed is looking at average hourly earnings “to see if they can get any pop in them.” First, they’d like to see wage growth of about 3.5% — the first 2% from inflation and 1.5% from productivity growth. “The Fed has got the luxury right now, with inflation being low, that they don’t have to raise rates to fight inflation,” Elder noted. “This is buying them some time.”

What’s a business to do?

How much time the Fed will take is anyone’s guess, but even if it begins raising interest rates late next year, our experts believe it will be done very gradually, so there is very little need to plan for a significantly higher cost of borrowing in 2015. Even if interest rates begin to rise in early 2016, the upward trajectory is likely to be a gradual one.

Elder believes that, when the time comes, the Fed will raise rates by a quarter of a point at each Federal Open Market Committee meeting. The FOMC holds eight regularly scheduled meetings per year, and other meetings as needed. The next regularly scheduled meeting is set for Dec. 16 and 17.

“I think there is a possibility that they would do a quarter of a point and then hold off for a meeting,” Elder said. “They’re going to do it the old [Alan] Greenspan way, but when they do it, it will be very slowly because they are very afraid of raising rates too quickly and looking up a couple of quarters later and finding we’re back at recessionary levels. I think they are terrified of that.”

(Continued)

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