The FOMC voted unanimously to raise the federal funds rate target on Wednesday to 5 percent. This was the 16th increase in the fed funds rate target and brings the rate to its highest level since early 2001. Fed chairman Ben Bernanke opened a can of worms a couple of weeks ago when he indicated that the Fed might pause in their rate hikes to see how the economy is doing, but a pause would not mean that the rate hikes were complete. He muddied the waters further when he allegedly told CNBC anchor Maria Bartiromo that market players misunderstood his remarks. The Bartiromo Affair, as it has been called, only confused matters further, an irony not lost on Fed watchers who were expecting "Gentle Ben" to be more transparent than his predecessor.
The post-meeting statement on May 10 was slightly altered from the March 28 statement. For instance, the reference to economic growth risk was removed. It appears that Fed officials are less worried about economic growth and expect that the rapid growth of the first quarter will not be repeated in upcoming months. Furthermore, the Fed does not appear to be worried that economic activity will soften too much at this stage of the game.
"Economic growth has been quite strong so far this year. The Committee sees growth as likely to moderate to a more sustainable pace, partly reflecting a gradual cooling of the housing market and the lagged effects of increases in interest rates and energy prices."
"The Committee judges that some further policy firming may yet be needed to address inflation risks but emphasizes that the extent and timing of any such firming will depend importantly on the evolution of the economic outlook as implied by incoming information. In any event, the Committee will respond to changes in economic prospects as needed to support the attainment of its objectives." |
But Fed officials remain concerned that rising energy prices along with rising wage increases could potentially hurt the core inflation rate. As one can see in the chart above, the core inflation rate appears stuck at 2 percent. Fed officials have indicated on several occasions that this is the top of their comfort zone.
"As yet, the run-up in the prices of energy and other commodities appears to have had only a modest effect on core inflation, ongoing productivity gains have helped to hold the growth of unit labor costs in check, and inflation expectations remain contained. Still, possible increases in resource utilization, in combination with the elevated prices of energy and other commodities, have the potential to add to inflation pressures." |
Wednesday's news appeared to have little impact on bond and equity markets, although it allowed the dollar to sink further. The post-meeting statement did not change the views of most economists and market players - that is, they are still unsure whether the Fed will raise rates further without a pause (meaning a rate hike in June and perhaps August) or whether they will pause in June and/or August, and raise rates again in the fall. Most likely, the peak federal funds rate target has not yet been reached. It will almost certainly be higher than 5 percent. But the timing remains a mystery.
This does not mean that Fed chairman Ben Bernanke is retreating on his promise to be transparent and disclose as much as is practical. It means that the Fed doesn't yet know what the appropriate fed funds rate target peak should be - and where the economy and inflation is exactly headed at this time. It doesn't matter too much who is at the helm of the Federal Reserve Board today. We would have seen the same result with almost any Fed chairman.
WHAT ABOUT CONSUMERS?
I used to see banks announce prime rate changes soon after the Fed made a rate change announcement. These days, prime rate changes appear buried in the news. Rest assured that your bank has increased its prime rate in tandem with the FOMC announcement! If your bank is anxious to get your business, they might offer you a home equity loan at Prime minus 1 percent. I've seen my local bank advertise that loan for the past couple of months. However, there is no question that loan rates are going up on the whole.
The chart below shows how mortgage rates have moved in tandem with 10-year note yields instead of the fed funds rate. Yields on 10-year notes have definitely moved higher in 2006 relative to the previous year. Incidentally, current mortgage rates (we only have data for the first week of May thus far) are at their highest levels since the June-July 2002. Ten-year note yields are at their highest levels since May 2002. Most economists are looking for higher yields on 10-year and 30-year Treasury securities, and this will translate into somewhat higher mortgage rates in coming months.
Credit card rates appear stable in the chart below, but did indeed start to turn up in 2005. The most recent figures available for credit card rates in the first quarter already show more rapid escalation. Since most credit card rates are tied to the prime rate these days, look for higher rates in coming months. Incidentally, when the fed funds rate target was last at 5 percent, in the first quarter of 2001, credit card rates were much higher - running at 15.7 percent. When we get the second quarter figures in the next month or so, they are likely to run closer to 14 percent than 15 percent. This reflects the greater magnitude of competition in the credit card market today versus five years ago. More consumers were using home equity loans or refinancing mortgage loans to finance their purchases in 2004 and 2005 than in 2000 or 2001. Credit card companies have continued to offer zero interest rates for balance transfers or new purchases for limited time periods to entice customers even as interest rates have increased over all. This has served to hold down credit card average rates. Competition remains tough in this market, so it is possible that credit card rates will not return to the same high levels we have seen in the past, even as they are headed higher.
Auto financing companies compete with banks - and are often tied to automakers - and thus are able to offer lower loan rates on cars than one would expect giving a rising rate environment. Notice that auto loan rates have come down in 2006 despite the fact that interest rates have increased. Domestic automakers are subsidizing their finance companies so that they could sell more cars.
INTEREST RATES AND THE STOCK MARKET
Conventional wisdom suggests that rising interest rates are negative for the stock market because higher rates curtail investment projects. At the same time, higher interest rates are often accompanied by stronger economic growth - which is positive for corporate profits. Of course, a rising profit environment bodes well for the equity market. In any case, if one were to look at only the interest rate side of the equation, one would not get the sense that rising interest rates are bad for stocks! The chart below compares changes in the federal funds rate target to the Dow Jones Industrials, the Nasdaq composite and the Russell 2000. The stock market indexes are tied to December 31, 2003 = 100 so that we could put them on one graph. In addition to showing that rising interest rates are not always bad for the stock market, this chart also shows that the Russell 2000 has outperformed the rest of the market by a wide margin. While the Dow Jones Industrials were only 11.4 percent above year end 2003 levels on May 10, 2006, and the Nasdaq composite index was only 15.8 percent above year end 2003 levels, the Russell 2000, measuring the small cap market, was up a whopping 39.3 percent above year end 2003 levels after the FOMC rate hike on May 10.
THE BOTTOM LINE
Fed officials voted unanimously to raise the fed funds rate target by 25 basis points to 5 percent. The post-meeting statement was altered to show a shift in the balance of risks, but the bottom line was not changed: more firming may be needed. The Fed left an open door as to when they intend to firm further.
Fed Chairman Ben Bernanke has a reputation of promoting transparency and greater disclosure. He is likely to be more forthcoming as time goes on. But the economic tea leaves are not so easy to read these days and his lack of transparency may be reflecting his lack of a clear outlook rather than an intention to be obscure.
Anyone can predict that consumer loan rates will be higher as the fed funds rate target translates into a higher interest rate environment overall. While mortgage rates and credit card rates as well as home equity loans rates are sure to rise in coming months, auto loan rates might see a slightly different trend. Domestic automakers are quite concerned about their production and sales, and this may lead them to continue to subsidize auto loans.
But there is no question that saving will be more profitable than borrowing in coming months.
Evelina M. Tainer, Chief Economist, Econoday
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