The Fed's eventual rate hike may dislocate markets in the short term, but higher rates are necessary to bring us back to normal, says Morningstar's Bob Johnson.
Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. We got a few pieces of potentially interesting economic data this week. I'm here with Bob Johnson--he is our director of economic analysis--for his take.
Bob, thanks for joining me.
Bob Johnson: Great to be here today.
Glaser: Let's start with the Fed minutes. Obviously, when the Federal Reserve is going to raise rates has been a top question for a lot of investors. Did we learn anything from the minutes of the January meeting?
Johnson: Well, there are a bunch of very different aspects of it. I think that a lot of focus was on that there was no hurry to raise rates--that's what people took away from the minutes. And the primary basis for that was that they used the adjective "many" committee members felt that raising rates too soon could be harmful to the economy. Then, [the notes referred to "several" members who were worried about inflation]. So, the fact that "many" is bigger than "several" seems to indicate that the Fed is kind of on hold for rates right now.
Glaser: Did you hear anything else that seemed interesting in terms of whether they are worried about inflation?
Johnson: They are very focused on inflation right now, and they are afraid of sending the wrong signal. And they are a little afraid of what happens if inflation is kind of low and they want to raise rates. So, they are really focused on the inflation data, and they are wondering, "Should we include energy? Should we not include energy when we think about this?" They are also looking at whether they use surveys of people and what they think about inflation--which says that everybody thinks we are going to return to kind of this 2% normal-inflation level, which is just where we want them to be.
But then you look at the data based on the TIPS, the inflation-adjusted securities that the government issues, and it implies a much lower rate of inflation, which has got some of them worried. They're kind of having a big argument in the notes about which one is the right one. So, there are a lot of little interesting tidbits like that in there.
And I guess the third thing that was interesting to me is that even though [putting off raising rates] was kind of the implied language, there was an awful lot of linage in the actual minutes about, "Well, when we do change, how do we announce it? Do we announce multiple steps? Do we announce it here? How do we do it and what are the mechanics of announcing it?" And if it was really far away, I don't think they would be arguing about the mechanics of how they announce it. So, I think it looks like there is something coming this year, but I'm still thinking it's going to be later in the year than earlier in the year. But many people disagree with me on that.
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Glaser: But if it's earlier or if it's later, does that have a big impact, at least on an individual investor?
Johnson: No. I think the short-term rates need to be about where inflation is, and right now it's pretty low. It's probably about 1%, but the Fed funds rate is still under that. I think the rates need to approach each other to be a normal economy. And at some point, it's going to adjust. Whether it's in June or whether it's in September, I think we have to equalize at some point. They can't do this artificial thing for too long or eventually buyers in the market will figure it out and they will bet against it anyway.
Glaser: You don't seem that concerned about if it's June or September. Why is the market so fixated on the exact timing, then?
Johnson: The market is very fixated because the day they actually announce the rates going up, it's probably going to be a very bad day in the market. We could be down 5% or 10% in a day. We could see dislocations in the bond market. We could see a hedge fund caught in the wrong position. [It could] cause some type of financial distress. So, that's why everybody is so worried about the exact day.
But again, if we've looked at the other times they've changed things, we've had these short-term impacts, and then we could just go back to normal again. So, I don't want to be the day trader out there who is probably going to get massacred one way or another when they do this. But instead, I'm focusing on the longer term, in that higher rates are necessary to bring us back to normal. The last time we actually moved rates a little bit higher in the so-called "taper tantrum," it actually caused a big boom in the housing industry because everybody rushed out to beat any more rate increases. And then you've got older people and retirees who want more money on their savings, and certainly it's going to help in that category. So, I don't think a short-term move in rates is going to destroy things.
Glaser: Let's turn to industrial production. Those numbers have been highly impacted by what's happening in energy. What's your take on that?
Johnson: First of all, I want to strip out and look at the manufacturing part of it. I don't want to really look at utilities, and I don't want to look directly at the mining industry. The industrial production figures were up 0.2% in January. That annualizes to about 2.2%. We've been running 4% or 5%. So, the numbers were disappointing even when you toss out some of the categories I mentioned. Clearly, we've gone into a slower environment there--and energy is an important part of the index here. And I think what's happening is the drilling-equipment part of it was actually down 10% in this month's report, so it's really a pretty dramatic number. Gasoline and things that businesses and consumers buy held their own, and the actual production of oil was off just a [tiny bit].
Glaser: What's your forecast, then, for manufacturing in 2015? Will it be difficult to repeat the success of last year?
Johnson: Yeah--2014 was a great year for manufacturing. We got close to a 5% year-over-year type of number. So, that's really a stellar performance, especially so far into an economic recovery. This year, we've got a lot of factors working against us. The strong dollar is going to affect exports. We've got a slowing commodity market, and that means less commodity mining equipment. So, that's going to be a slow market probably for us in 2015. So, you've got a number of factors, and then you've got the whole energy sector kind of just beginning to slow up. All of those things will pull down the industrial-production number, and I think we are probably going to end up the year more like 3% instead of the 4% to 5% that we've been used to.
Glaser: Finally, we got some housing data this week. Any signs that there is a better recovery in that sector?
Johnson: Unfortunately, not yet. I think the numbers weren't awful, but we were down in starts and permits in January compared with December. Some of that is obviously probably weather-related. We saw a big dip in the Midwest numbers, but that's not the entire story. But nevertheless, housing is not booming. And with permits, you don't have to put a shovel in the ground, so those kind of hold up a little better than starts, usually. But we really didn't see the permits number look good, which means it's going to be hard for the housing recovery to get much better until at least March or April, unfortunately. And certainly, one of the areas of strength has been the multifamily sector, which actually did show some improvement from December. So, that was one bit of good news.
Glaser: Bob, thanks for the updates today.
Johnson: Thank you.
Glaser: For Morningstar, I'm Jeremy Glaser. Thanks for watching.
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