Fed's Rate Hike

A Look at the Fed’s December Rate Hike

For many equity investors, the last seven years were enjoyable due to lofty returns as the Federal Reserve’s benchmark interest rate resided at near-zero levels. Even in 2014 and much of 2015, while many believed that the time for a hike had arrived, investors lucked out as the Fed decided to leave the rate unchanged.

The thought was that if the U.S. economy wasn’t strong enough, then a rate hike would be deferred, further continuing the trend of cheap capital to stimulate economic growth. And when rates remain at such paltry levels, many investors move money from bonds to stocks in search of better returns, increasing the demand for stocks and therefore their prices. Essentially, they believed bad news [for the economy] was good news [for stocks], and vice versa.

But this long-awaited deferral ended in December 2015 when the Fed finally felt comfortable with increasing the benchmark rate by 25 basis points to 0.5%.

So, what are the implications of this action?

The short answer is that such a small increase alone will not be material to most markets. But because this increase is one of several more to come over the next few years, the long answer is that housing, as well as labor and financial markets, are sure to realize some changes.

Because the housing market is such a driver of the overall economy, many are concerned about the impact of an increased rate. A rate hike certainly makes mortgages more expensive. But does this suggest harm to the overall economy? Some, like Wells Fargo CEO John Stumpf, say, “If we do see some rate increases coming, because it reflects a stronger economy, nobody is going to not buy a house because the mortgage rates went up.”        

Still, others, like Bank of America CEO Brian Moynihan, disagree. “If you see rates rise, you’ll see the mortgage market slow down.”

So, if the rate hike has the potential to hurt consumers, then why did the Fed do this?

The crux of the Fed’s job, termed the “dual mandate,” is to:

1) Maximize employment and

2) Maintain healthy inflation (2% annually).

In order to abide by these objectives, the Fed manipulates benchmark interest rates, fluctuating the money supply. When employment and inflation are at high levels, the Fed gradually raises rates, decreasing the money supply. Conversely, should employment and inflation approach the low side, then the Fed lowers rates, increasing the money supply.

Now, while the unemployment level is fairly good at <5%, the inflation rate for 2015, including food and energy prices, is still quite low at approximately 0.5%.

So, what gives with December’s rate hike?

Because the Fed’s decisions are not grounded on black and white economic data, a lot of their conclusions are based on hypothesized insight. In other words, they conduct research-driven experiments based on presently-available figures. The Fed’s reasoning for the recent hike is to combat high inflation before it attacks. Oftentimes, monetary policies can take years to become material. By acting with foresight, the Fed is hoping to avoid problems in hindsight.

Of course, with the strengthening dollar, which makes U.S. exports less profitable, and a slowing manufacturing environment, the Fed might be hard-pressed to further increase rates in the short term.

At 0.5%, the Fed’s benchmark interest rate is still very low, historically speaking, which may mean that consumers will remain tempted to mortgage a large purchase. It could even be said that the fear of missing out on a low rate may be impetus enough to fuel further borrowing. Maybe good news can be good news. But only time will tell.

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