Investors are looking for the Federal Reserve to finally begin raising interest rates when it meets in December, following a strong employment report issued by the Labor Department in early November. But a lot could happen in the month leading up to the central bank’s next policy meeting.
The last time the Federal Reserve raised short-term interest rates was in 2006, not long after the current Fed Chair Janet Yellen’s predecessor Ben S. Bernanke had taken over the reins from long-term Chairman Alan Greenspan. In the nearly ten years since, the United States economy has slowly recovered from one of the deepest recessions on record, from 2007-2009, with the help of ultra-low interest rates. The Fed reduced its target for the Fed funds rate to near zero in late 2008, where it has remained ever since.
Clearly, central bankers are reluctant to remove the support of low interest rates for the economy, particularly in the absence of a clear trend toward higher reported inflation. Higher rates historically go hand in hand with an overheating economy, and it would be hard to make an argument that the recent quarterly rate of GDP expansion, at 1.5% for the September quarter, was anything special. [The GDP figure was later revised to a gain of 2.1% on November 24, 2015.]
But there is a case to be made that labor market conditions are sufficiently strong for the Fed to finally push rates off the bottom. The economy is on track to add more than two million jobs in 2015, which is healthy, while the unemployment rate has ticked down to 5.0%. At its worst level in the last recession, the unemployment rate was double that figure, at 10.0%.
Here is where the Fed is charged by some observers with moving the goalposts. At one time, the central bank had intoned that it would be looking to raise interest rates when the unemployment rate fell to 6.5%. That figure was surpassed more than a year earlier, but the Fed has not yet budged on interest rates, instead broadening the factors that would influence its decision-making to include wage gains. On that count, there were promising signs in the October employment report that workers’ pay was picking up, with average hourly earnings rising 0.4%, after showing no change in September. In the past 12 months, wages have risen 2.5%. But although that is the fastest pace in six years, it comes after a long period of stagnation.
Very likely, Federal Reserve officials would prefer to see further evidence that workers’ pay is picking up in the next Labor Department employment report, scheduled to be issued on December 4th. That will come 11 days prior to the start of the Federal Open Market Committee’s two-day meeting on December 15th. (The FOMC is the Fed’s policy-making arm.) If the situation were to remain the same as it is now, there is a strong chance that the Federal Reserve will, at long last, raise rates.
The hitch is the economy’s advance has often been a two steps forward, one step back affair in recent years. No doubt, the Fed will be figuring in the tone of all the economic data available, on top of labor market conditions. Moreover, any disruptive events, such as a recurrence of the unsettling situation in Greece, China’s currency devaluations, or another terrorist attack, as took place in Paris, could stay the Fed’s hand. But if we remain on course, there is good reason to expect a small, quarter of a point, interest-rate hike in December. The minutes from the last FOMC meeting indicated the Fed was leaning in that direction. Further hikes will presumably be data-dependent.
For investors, the financial sector stands to be a beneficiary of higher interest rates, assuming the bond market correctly assesses the Fed’s intentions and pushes long-term interest rates higher ahead of the central bank’s moves. Lenders, including Bank of America (BAC) and PNCFinancial (PNC) would then be in line to benefit from wider margins on loans. Insurance companies, such as Prudential Financial (PRU) would enjoy better income from bonds, too. The caution is that there have been a few false starts before with respect to a shift away from rock-bottom rates.