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The Long Hike

Posted on August 26, 2014

“There is no simple recipe for appropriate policy in this context…” – Janet Yellen

2014-08-26_long_hike_FREE.jpgSince the early 1980s the Federal Reserve Bank of Kansas City has hosted its annual economic symposium on the beautiful valley floor of Jackson Hole, Wyoming. Surrounded by the towering Teton Mountains, central bankers and economists from around the world gather for this influential conference to share and discuss their views on a particular topic important to the US and worldwide economies. This year’s conference, which was held last week, focused on the theme “Re-Evaluating Labor Market Dynamics”, and as usual all eyes were on the US Fed Chair in expectation of even the slightest hint as to when US monetary policy might shift next.

As we recently explained in An Update On The Fed, now that quantitative easing is on its way out the focus has shifted to when the Fed will begin to hike short-term interest rates. It’s hard to believe, but it is going on six years now since former Chairman Ben Bernanke took short term rates down to the zero bound. (NOTE: For a primer on the Fed’s basic policy tools and how short term rates are set, see Fed Ed: Pulling Back The Curtain.)

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The question of when Chairwoman Yellen and the FOMC will begin the next rate hike cycle is an important one. Most interest rates through the economy are set, either directly or indirectly, in relation to the effective Fed Funds rate. Thus, as the Fed Funds rate increases, so will rates on mortgages, credit cards, small business loans and even government bonds. Given the amount of debt still present in our financial system, higher rates will be a headwind to private and public sector spending (although they will be good for savers).

As we would have predicted, Yellen did not give any new clues as to when rates might be heading higher. Instead, she regurgitated many of the same comments that we’ve heard in her other key speeches this year, reinforcing the idea that we still have a long hike between here and her next policy move. The two primary inputs into her interest rate considerations, inflation and labor, remain convoluted by the various structural distortions left over from the Great Recession. It’s hard to know how much slack is really in the labor market given the precipitous drop in the participation rate and the millions of part-time workers who wish they were working full time. All of this confusion has led to previous estimates of “full employment” around 6.5% to be revised lower to 5-5.5%. Additionally, the lack of any real inflation, coupled with glacial growth in wages, leaves Fed officials feeling no pressure whatsoever to be in a hurry to raise interest rates.

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In Janet Yellen’s words,

These complexities in evaluating the relationship between slack and inflation pressures in the current recovery are illustrative of a host of issues that the FOMC will be grappling with as the recovery continues. There is no simple recipe for appropriate policy in this context, and the FOMC is particularly attentive to the need to clearly describe the policy framework we are using to meet these challenges. As the FOMC has noted in its recent policy statements, the stance of policy will be guided by our assessments of how far we are from our objectives of maximum employment and 2 percent inflation as well as our assessment of the likely pace of progress toward those objectives.

Current consensus estimates for the timing of the Fed’s first rate hike place the move somewhere in mid-2015. Of course, we remember when these same consensus estimates were calling for a rate hike in mid-2010! If the last few years have revealed anything, it’s that trying to predict what the US Federal Reserve is going to do next can make even the best and brightest among us look foolish. Despite the uncertainty, it is definitely true that current monetary policy will have to “normalize” at some point – and that means higher rates (eventually). In order to prepare for this development we are keeping our fixed income exposures underweight long-term targets and short-term in duration. This will minimize the negative impact of rising rates when they do come. Additionally, maintaining broad diversification with core exposure to asset classes that will likely benefit in a rising rate environment (ie, growth and inflation beneficiaries like equities and real estate) ensures that we’re not betting portfolios on any one particular outcome or theme, but rather positioning clients to generate a lower volatility, more consistent return stream that can meet expectations in a variety of economic environments over time.


david_headshot_bw.jpgAuthor David Houle, CFA is a founding member of Season Investments. He serves as the firm's Chief Compliance Officer as well as sitting on the investment committee overseeing the management of client assets. David spent nearly ten years in various roles primarily managing individual client assets prior to co-founding Season Investments. David graduated with a degree in Finance from Colorado University in Colorado Springs in 2003 and earned the Chartered Financial Analyst (CFA) designation in 2006. David and his wife Mandy have three children and spend most of their free time with friends and family.


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