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Question of the Week - December 21, 2015

Question of the Week - December 21, 2015

Guest Post - Monday, December 21, 2015

2016 (Part 1): How is the economic environment shaping up?

To some degree, more of the same, but perhaps some shifts are likely. Economic conditions continue to demonstrate signs of repair in the long aftermath of the financial crisis, and market valuations have normalized. Finally, the question has turned from when will interest rates start to rise, to how quickly and how dramatically.

Historically, interest rate hikes have scared people. In some cases, this is for good reason. If an economy is accelerating at full capacity, with credit creation high and inflation pressures mounting, a rate hike is intended to (and usually results in) a slamming on the brakes. While this takes time to filter through to the desired effect, the brakes are meant to slow the car down from careening out of control. If rate hikes are large enough, impacts can be widespread, resulting in more expensive commercial and mortgage loans, which tightens credit, as well as causes the present value of assets (like equities and real estate) to fall when higher rate assumptions are dropped into financial models. This is not to mention the impact on bonds, especially the longer duration variety, which are extremely interest-rate sensitive due to the nature of their fixed coupons.

When a less-transparent Fed of decades ago would make a policy move, it wouldn't tell the world about it, but treasury markets would find out soon enough through the Fed's 'open market operations' (the FOMC's namesake). So, there was element of opaqueness in their policy that we no longer have today.

Today, rates are extremely low (we were about to say they couldn't have gotten much lower than zero, but in Europe, they actually have gone below zero). Regardless, with rates moving higher by only a quarter point, they continue to be stimulative, just not as much so as before. The Fed has taken pains to ensure their message is clear—that they intend to keep policy accommodative, but also to 'normalize' rates away from emergency levels. Arguably, some economists think this could have been done some time ago, but the Fed seems to have its reasons. The speed by which the Fed raises rates will depend on the conditions of the Fed's mandates, including the speed of labor improvement, such as further decline in the unemployment rate, rate of change in inflation, as well as other factors affecting monetary stability, such as economic growth, credit and, likely, conditions overseas.

The Fed has transmitted policy to such a detailed degree that every word of every speech and communication is parsed for possible meaning and this has its own implications—if any policy move deviates from expectations, market reaction could be dramatic. So, we would expect this carefulness to continue in 2016.

Rate increases that occur at a tempered, expected pace don't need to be disruptive. It's the rate shocks in response to inflation or overdone credit expansion that often are most rattling. It is entirely possible that current conditions such demographics and productivity hurdles may keep economic growth tempered for the foreseeable future—we may not consistently see the 3-4% level that we've become used to in past decades. At the same time, such slow growth has minimized the natural excesses that occur in business cycles and may keep the current cycle running longer than it normally would—perhaps for a few more years.

What could go wrong and/or cause the expected Fed timing to get off track? As always, any number of things.

  • Inflation could tick up, either coupled with rising wages or a sharp recovery from oil/other commodity prices. This is hard to imagine, but these types of things can often come as a surprise. Faster than expected inflation could speed up the Fed's rate hike timetable and magnitude.
  • Economic growth slows again, as manufacturing continues to weaken and/or services also tick downward. This could take a hike or two off the table, slowing down the Fed's pace.
  • Employment improvement stagnates or worsens again for whatever reason. Being a key part of the Fed's mandate, this could slow the pace/amount of interest rate change. On the other hand, improvement beyond expectations could push the Fed to move faster/higher.
  • Overseas developments potentially affecting the global/U.S. economy.

More next week on potential impacts on specific asset classes.

Read our Weekly Review for December 21, 2015.

Read the previous Question of the Week for December 14, 2015.

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