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The Fed and the Future Path of Interest Rates

Posted by Jeremy Merchant on Apr 1, 2015 5:00:00 PM
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As expected, the Federal Open Market Committee (FOMC) removed "patient" from its recent statement to indicate that the Federal Reserve (Fed) was moving closer to raising short-term interest rates. The Fed will now concentrate on incoming data to determine the optimal time to begin normalizing interest rates after six years at zero percent.

According to the Fed's mandate, the Fed must attempt to set policy that will eventually lead to full employment and 2 percent inflation. Currently, inflation and employment are heading in opposite directions and economic reports have been mixed at best. As it stands now, GDP growth will again struggle in the first quarter. Economists are now projecting that GDP will be at or below 1 percent in the first quarter. GDP growth of 1 percent is not historically representative of an economy where the Fed raises rates. Some Fed members continue to feel that it is better to be a little late and risk higher inflation in the short term than to risk a deflationary environment that is difficult to overcome (i.e. Japan).

Employment Gains and Low Wage Growth

During the last 12 months, employment gains have been the bright spot in the U.S. economy. The U.S. economy has produced an average of 275,000 jobs per month and, at 5.5 percent, the unemployment rate is at the economic cycle's lowest point. In addition, hours worked are up and many of the new jobs created are now full-time positions. These employment gains have helped the economy (i.e. consumer spending) compensate for low wage growth.

The Civilian Unemployment Rate and Year-Over-Year Growth in Wages

As illustrated in the chart above, the 50-year average for wage growth is 4.3 percent. Wage growth in the U.S. has been less than 50 percent of its 50-year average since the last recession. Recent economic reports on retail sales and industrial production have also been disappointing and have fallen each of the last three months. Much of this can be explained by a stronger dollar, plummeting oil prices, bad winter weather, and the West Coast port closure. However, a stronger dollar and oil prices are not likely to reverse their current course anytime in the near future. Thus, these forces will continue to put pressure on earnings in the U.S.

The Eurozone Economy

On the bright side, especially for investors in Europe, things are slowly improving. The Eurozone economy, which is still 2 percent smaller than it was prior to the recession, is projected to grow at approximately 1.5 percent this year. This is about twice as fast as last year and would be a substantial improvement. The depreciation of the Euro, lower oil prices and less stress in the banking sector are slowly pushing the Eurozone economy forward. Nonetheless, we remain cautious in Europe due to ongoing negotiations with Greece and the possibility of a default and eventual exit from the Euro.

Interest Rate Projections

While the U.S. economy continues to adjust to a stronger dollar and lower oil prices, earnings are likely to be constrained in the first quarter. In addition, inflation as measured by the Consumer Price Index (CPI) has been non-existent which has raised concerns of deflation among some Fed members. Much of the downward pressure on inflation can be traced to falling oil prices as evidenced by Core-CPI. Core-CPI has been fairly consistent even though it has remained below the Fed's target of 2 percent. Nonetheless, the Fed lowered its interest rate projections by 50 bps this year to a range of 50 - 75 bps at year-end. This should give the Fed the time and maneuverability to ascertain the true trajectory of the U.S. economy as the year progresses.

On a separate note, if you have not viewed our recent Quarterly Investment Video Update, we have attached the video below for your convenience.

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Disclaimer: This blog is intended for informational purposes only and should not be construed as individual investment advice. Actual recommendations are provided by RAA following consultation and are custom-tailored to each investor’s unique needs and circumstances. The information contained herein is from sources believed to be accurate and reliable. However, RAA accepts no legal responsibility for any errors or omissions. Investments in stocks, bonds and mutual funds may increase or decrease in value. Past performance is no guarantee of future results. Any of the charts and graphs included in this blog are not recommendations for the purchase and sale of any security. 

Topics: Investment Updates