Higher Rates...Sooner Rather Than Later?

Written by Jeff Thredgold, President, Thredgold Economic Associates

April 12, 2011

Odds are rising that the Federal Reserve, this nation’s central bank, could decide to push its key interest rate up later this year in an effort to address rising inflationary pressures.  Such a move would follow recent interest rate increases by various central banks around the globe, while others have remained silent…

…such a move, or more likely a series of moves, can’t come fast enough for millions of retirees or for those close to retirement

Background
The Great Recession, and the painful near-financial market meltdown of 2007-2008, led the Federal Reserve to reduce its most important interest rate—the federal funds rate—to an all-time low target range of 0.00%-0.25% in mid-December 2008, or 28 months ago.  Other central banks around the globe largely followed suit.

In addition, the Fed has been throwing mud (money) at the wall for the past three years, hoping to see what would stick in terms of monetary efforts to help stabilize domestic and global financial markets, while providing enormous liquidity (money) to calm widespread fears.  The initial program…now referred to as QE1 (quantitative easing)…provided $1.7 trillion in purchases of U.S. Treasury notes and bonds, mortgage-backed securities, and debt issued by U.S. Government agencies.

The second program, QE2, began late last year and is set to conclude its purchase of $600 billion of similar securities by June 2011.  Some suggest that this program could be ended earlier.  Most financial market players do not want to see implementation of a possible QE3, as it would likely stoke inflation fears even further.

Rising Inflation
Even as the Fed has been providing unprecedented amounts of monetary stimulus to the economy, world events have led inflation pressures higher.  Political turmoil in the Middle East and in Northern Africa, combined with fears of similar unrest focused on Saudi Arabia, has led oil prices higher. 

Industrial commodities and food prices, tied to solid global economic growth (can you say China?) and some stockpiling (can you say China again?), have also pushed inflation and inflation expectations higher.  Any disruption to Saudi oil flows could see oil prices temporarily move to record levels.

Fed Statements
Various Federal Reserve officials in recent weeks have suggested that the time will soon approach wherein the Fed must address these rising inflation worries.  While the Fed’s primary measure of inflation is still below its desired 1.5%-2.0% annual objective, it has been rising.

Note:  The Fed prefers to measure “core” inflation, which excludes volatile food and energy costs, each of which have risen sharply.  Some suggest that the Fed’s core inflation measure is perfectly fine for those who don’t eat or drive.

The Fed is typically more focused on “inflation expectations” as opposed to what happened to price levels in recent months.  This view might also support the idea of modest tightening sooner rather than later.  The Fed doesn’t want to fall behind the curve and let inflation anxiety rise sharply higher.

The ECB
A majority of the global community’s most critical central banks have already leaned in the direction of inflation containment.  The Chinese central bank, seeing inflation running near 5.0% annually, recently tightened (pushed up) its key interest rate for the fourth time in recent months. 

Central banks in more than a dozen nations have tightened policy.  The central banks of Japan and England have decided in recent days to maintain current historically low interest rate levels.
   
The globe’s second most important central bank, the European Central Bank, which conducts a single monetary policy across Europe, opted as expected on April 7 to begin pushing its key rate higher.  The ECB’s key rate was boosted to 1.25% from an historic low of 1.00%, the first upward move since 2008.

The ECB’s objective is to address inflation now exceeding a critical target of 2.0% annually.  Additional tightening moves are expected in coming months, with the next move in June.

One major difference between the ECB and the Fed is the ECB’s singular mandate to keep inflation under control.  Two hyper-inflations in Germany following WWI and WWII largely account for the inflation paranoia.

The Fed’s dual mandate is to address inflation, while also keeping an ear to the ground regarding unemployment.  You can take it to the bank that the sharp decline in the U.S. unemployment rate from 9.8% last November to 8.8% in March provides the Fed greater flexibility to tighten policy than without such a move.

A Boost for Savers
The traditional viewpoint regarding Fed policy is that lower short-term interest rates help stabilize or stimulate the economy, while rising rates ultimately slow the economy.  The reverse is all too true for those of retirement age who depend on interest income to help maintain solid or Spartan retirements.

One has only to ask their parents or grandparents about sharp cuts in spending tied to extremely low rates on money market funds, savings accounts & CDs, and bonds.  Millions of retirees “did all the right things” of saving diligently for retirement, and shifting more of their funds from equities (stocks) to fixed-income (CDs and bonds) to minimize stock market volatility.

Rates on safe or U.S. Government guaranteed short-term savings or money market funds earlier this year averaged 0.24% annually, one-tenth the level of late 2007 (The Wall Street Journal).  The reason?  All short-term interest rates are indirectly tied to the 0.00%-0.25% federal funds rate.

Any decision by the Fed to boost its federal funds rate to 0.50% or 1.00% or 1.50% later this year or in early 2012 through a series of incremental steps would help address the Fed’s commitment to keeping inflation under control.  Such a series of moves would also lead other short-term rates higher…

…for millions of retirees who primarily live on interest income, such moves can’t come soon enough

The Next Battle
The agreement between the major parties last Friday to keep government running through September 30 was a positive step.  As noted before, however, this skirmish was minor league as compared to what will emerge in coming weeks.