Interest Rates, the Economy, and Investors

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At the Federal Reserve increased interest rates in December, the U.S. stock markets have taken a considerable dip. The December increase was the first time interest rates have risen since 2006, but it sent shockwaves through the domestic equity markets. The declines have been enough to make some people question whether further interest increases are likely this year. The idea is to gradually increase interest rates as long as job growth remains strong.

Image via Flickr by FutUndBeidl

Expectations and Objectives

Initially the expectation was that the Fed would raise its rates incrementally starting in January as long as the country’s economic indicators remained strong. However, as strong as the economic numbers have been, the market was not supportive. In response, the Fed did not raise rates at its January meeting as expected and instead released a statement. “Inflation has continued to run below the Committee’s 2 percent longer-run objective, partly reflecting declines in energy prices and in prices of non-energy imports,” it explained.

“Inflation is expected to remain low in the near term, in part because of the further declines in energy prices, but to rise to 2 percent over the medium term as the transitory effects of declines in energy and import prices dissipate and the labor market strengthens further,” continued the Fed. “Given the economic outlook, the Committee decided to maintain the target range for the federal funds rate at 1/4 to 1/2 percent. The stance of monetary policy remains accommodative, thereby supporting further improvement in labor market conditions and a return to 2 percent inflation.” The Fed also attempted to assure the public that they are “closely monitoring global economic and financial developments and is assessing their implications for the labor market and inflation, and for the balance of risks to the outlook.”

Analyst Opinion

So the big takeaway was that the Fed is going to keep raising rates as long as the economy continues to do well. However, the economy is not immune to effects of the markets. If the markets react negatively to rate increases, the pain could be felt on the broader economy.

As such, some analysts are expecting a rate increase next quarter. “I still think they are going to raise rates in March,” said Gus Faucher, a senior economist at PNC Bank, in the New York Times. “I don’t want to oversell it, but I think that while what goes on overseas has an impact on the U.S. economy, what’s much more important is what goes on domestically.” Goldman Sachs is more conservative. The investment house “has dumped expectations for another interest rate rise from the Federal Reserve in March, owing to tighter financial conditions,” writes the Financial Times. “The bank’s US economists Jan Hatzius and Zach Pandl now expect the Federal Open Market Committee to keep rates unchanged at the March 15-16 meeting and instead pull the trigger again at the June meeting.”

Reversing the Policy on Interest Rates

In addition, there are those who believe that the Fed will stop increasing rates and possibly return to easing. “Whether such sustained growth will take hold this time around today remains to be seen, but I am less than optimistic,” says CFA Eric Parnell in a recent Seeking Alpha article. “I am more of the opinion that the Fed will likely soon be forced to stand down from any further rate increases and may eventually be induced to return to its easier policy ways.”

“Knowing that the only stimulus that has sustainably elevated the stock market over the last 15 years has been daily U.S. Treasury purchases as part of a QE program, these are the keywords to monitor for from the Fed. Not negative interest rates or anything else, as they have also proven equally ineffective in sustainably raising asset prices as demonstrated by stock performance in Europe and Japan in recent months,” continues Parnell. “It is specifically daily U.S. Treasury purchases. And if the Fed is not actually in the process of implementing daily U.S. Treasury purchases, we are unlikely to see anything other than some periodic short-term pops higher on Fed jawboning or eventual action.”

Going Forward

Goldman Sachs says that current economic activity in the United States suggests a modest expansion but that slowdown may be likely as soon as next year. For investors, the real issue isn’t the economic data, although that plays a role. Instead, investors need to be wary of how the market reacts to changes in the Fed’s policy.

One option is to focus new investments on the areas of the markets that have been hit the hardest by the expectation of higher interest rates. Utility stocks may be a good bet. There also may be some modest gains in real estate investment trusts (REITs) and development corporations as they will have lower costs than expected, at least in the short term.