The Fed will balance improving U.S. labor market data against continued low inflation and weak global growth in timing its first rate increase, says Morningstar's Bob Johnson.
Jeremy Glaser: For Morningstar, I'm Jeremy Glaser.
I'm here today with Bob Johnson, our director of economic analysis. We're going to look at what the Federal Reserve is weighing when it's thinking about raising rates and what the timeline for that could be.
Bob, thanks for joining me.
Bob Johnson: Great to be here today.
Glaser: First, let's take a step back and look at some of the extraordinary measures that the Fed has put into place, and that it now has started to take away. Where do you see us in that journey? How far away are we from being back to normal?
Johnson: I think we're still a ways away. We've executed three quantitative easing programs, and that's basically where they went out and bought long-term bonds and mortgages, which is unusual for the Fed. The Fed usually has a focus on the short end of the curve. It's called "quantitative easing" because it involves the purchase of long-term bonds that they haven't historically bought.
They were expanding that program every month for some time in the latest iteration of that, QE3, and now they're done expanding that program. They aren't selling any of the bonds yet, though, and even as they mature, they are replacing those bonds. So it's not exactly like their program is totally [unwound].
The other thing that they have done, even before they began the QE programs, is effectively take interest rates pretty much down to zero, and we've been there since 2009. And the question is, now that they've stopped buying more bonds, what's the next step they are going to take in their approach?
Glaser: If we think about a rate increase, speculation is sometime next year, what do you think is the pro case for raising rates sooner rather than later? What makes them think that now is the time to do it?
Johnson: I think the number-one thing to keep in mind is that at least some of the Fed governors have a very strong belief that this was really an extraordinary set of measures--the zero interest rate and buying back all these bonds--it was just out of the ordinary. It wasn't what the Fed's real mandate was.
So, they've been very cautious, and their thought is, we may not love the growth rate we're at, and we may not think the world is like catching fire, but on the other hand, these are extraordinary measures; let's cut them out. We don't know the long-term ramifications of some of the stuff we did. Let's just get these down before it gets too crazy.
Glaser: As they've been implementing these programs, employment growth is a key thing they are looking at. How has the strength in the job market been playing into these discussions?
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Johnson: I think the job market is beginning to heat up, and I think that's going to continue in 2015. That's certainly going to be part of their equation. Recollect, the Fed originally said it was going to start shutting these extraordinary programs down when the unemployment rate got to 6.5%. Lo and behold, right now we're at 5.7%. They kind of ducked and weaved, and said, well, maybe the participation rate is a little different or maybe unemployment needs to be a lower number. But they've never really said what the new lower number is.
In any case, we've come a long way. At the peak of the recession, we were at 10% unemployment. Even when this latest QE program began, we were at 7.7% unemployment. Now we're at 5.7% unemployment, and that certainly suggests that things are stronger, and we've accomplished what we were supposed to have accomplished with these programs. Our idea is not to get maximum growth here. It was to really improve the employment market, and we are kind of where we're supposed to be.
Glaser: What other data points could happen between now and sometime in 2015 that you think would sway them--for instance, a strong holiday season? What would be a factor?
Johnson: You hit on them. If the economic data comes in stronger than expected--and you've got this camp that believes these are extraordinary measures--it's hard to argue why keep them up when we don't know what Pandora's box problems they might create. Let's get them shut down.
We had a GDP revision for the third quarter this week that suggests the economy is a little stronger than they thought. We've had some relatively strong employment reports. And now we've got the potential for a holiday season, which I thought was going to be relatively strong. These would all be things that make them say, we better be a little cautious; we better step back. Those are the things that would make them possibly think about raising rates sooner than later--and sooner being March. I don't think it will really be much before that.
Glaser: But on the other hand, this is hardly a slam-dunk case to start raising rates. What are some of the factors that would argue for keeping rates at these extraordinarily low levels for longer?
Johnson: The Fed's dual mandate is to keep employment high and at the same time keep inflation low. But in fact, inflation has probably gotten too low. The CPI (Consumer Price Index of inflation) is about 1.5% right now, and their generalized target is right around 2%. So, we're running a little bit below on inflation, and given where gasoline prices are right now, that number could get even lower by the end of the year and early next year. In that case, they are running way below the inflation target, so why raise rates? Why upset the applecart? Their mandate is to stop inflation. Where's the inflation?
Glaser: What about the quality of job growth? Do you think they're worried about wage growth not being particularly robust?
Johnson: While the number of people employed has gotten better and the unemployment rate has come down, the amount of money that people make per hour has been relatively slow-growing, 2% or less. In some months it has been quite a bit worse. Without any kind of big acceleration there, the job market may not be as robust as some of the other data suggests, and therefore maybe they don't need to act just yet.
Glaser: How about housing?
Johnson: Now this is a very interesting one, and that would argue for keeping rates low for some period of time. Housing is absolutely the most sensitive to interest rates of anything else that's out there, and housing has been one of the big disappointments to me in 2014. I started out with one of the lower housing-starts forecasts and warned everybody that the big year of housing was going to be 2013--2014 would be nice but not as strong as 2013.
As it turns out, some categories are actually going to be down from 2013. Housing has been a big disappointment, even with rates having leveled off and actually started to come down again in the back half of the year. So I think the Fed has got to be very worried if they move rates higher that the housing market stalls out even more.
Glaser: The Fed is not making these decisions in a vacuum. What global central banks are doing is going to have an impact. How does the fact the ECB might be easing some more, and that the Bank of Japan is easing a lot … how does that impact the way that the Fed thinks about the timing of a rate increase?
Johnson: As the other central bankers look to the U.S., the last thing they want is for the U.S. economy to slow dramatically. We're the last important growth market, especially among developed countries, that's doing well. Obviously, as those countries depend on exports to the U.S., the last thing they want to see is a dramatic slowing in the U.S. So, they are certainly not cheering for a rate increase in the U.S.
The side effect that happens with interest rate [disparity] is, as the rates are much higher in the U.S., people buy the dollar, there is more demand for the dollar, which means the dollar goes up in value, and that begins at some point to weigh on the economy. So, the Fed has got to worry a little bit, if they bring rates up too fast, too hard, that they are going to create issues with the stronger dollar. It's going to wreck corporate profits. It's going to make us less competitive in overseas markets.
Glaser: Overall, then, what's your best guess of when the Fed is going to start raising rates, and where would you expect rates, or where should rates be, three to five years from now?
Johnson: I'm expecting the middle of next year still. I think that the situation in Europe is still a little bit soft. Clearly, China is softer than everybody likes. And China and Europe have taken measures that are already in place, but it will take another two or three months before they'll really cycle through yet. Until those other markets get a little stronger, I think they are going to be hesitant to act. So, I'm thinking the middle of next year. I certainly don't think things are so weak that it will extend into late next year, but I'll say June-July's timeframe, probably.
Glaser: With a longer-term outlook, is this going to be a relatively minor raise, and we will stay there for a while, or are rates going to just keep progressively getting higher, potentially, through the year?
Johnson: I think we're going to move higher, and it probably will happen at once, and we'll have kind of a spike, and then we'll pause. I've talked again and again about how long-term demographics and slow growth both argue that it's highly unlikely that we're going to have a huge spike in interest rates--that we would get back to a 1970s environment where we had 10% inflation, 15% inflation, and similar bond rates. I don't think we're headed that way at all.
I think that rates will be a little higher. They'll be a little bit closer to the inflation rate in the short run, and a percent or two above that for the 5- and 10-year bonds. So, I think we will move higher, but not dramatically so. Not enough that I'd be shifting my portfolio all over the place.
Glaser: Bob, thanks for your thoughts on interest rates today.
Johnson: Thank you.
Glaser: For Morningstar, I'm Jeremy Glaser. Thanks for watching.
