US Fed's downward revisions:
What does it all mean?
After reading my previous post ("US Interest Rate Forecasts: Policy Maker vs. Market Forecasts", March 22, 2015), a friend who is not in the field of finance asked, "What does all this mean to the average reader?"
Here's what I believe it means, and it's a matter of interpretation.
1) If interest rates are of concern to you, perhaps because you have borrowed money at a variable rate and would be adversely affected by an interest rate increase, you shouldn't get too worked up about the prospects of rising interest rates. They are likely to increase less than you were expecting, and later than you were expecting.
2) Since the Fed's mandate is to contribute to price stability, and since it raises interest rates to combat inflation, we now have reduced inflationary expectations associated with the Fed's downward revisions.
3) To the extent that low interest rates lead to higher asset prices (e.g. stock market prices, bond prices, real estate prices), this trend is likely to continue, all else being equal.
4) The US economy, despite being the best recovering economy in the world today, is still not strong enough to support higher interest rates. The rule at work here is that the more economic growth there is, the higher the prevailing interest rate. (In reality, it's the long-term interest rate that mimics the rate of prevailing economic growth. It is set by market forces. However, the long-term interest rate is correlated with the short-term interest rate over which the Fed has direct control.)
2) Since the Fed's mandate is to contribute to price stability, and since it raises interest rates to combat inflation, we now have reduced inflationary expectations associated with the Fed's downward revisions.
3) To the extent that low interest rates lead to higher asset prices (e.g. stock market prices, bond prices, real estate prices), this trend is likely to continue, all else being equal.
4) The US economy, despite being the best recovering economy in the world today, is still not strong enough to support higher interest rates. The rule at work here is that the more economic growth there is, the higher the prevailing interest rate. (In reality, it's the long-term interest rate that mimics the rate of prevailing economic growth. It is set by market forces. However, the long-term interest rate is correlated with the short-term interest rate over which the Fed has direct control.)
5) The Fed cannot always have things its way because there are other forces at play which are beyond its control. These would be market forces: the US dollar has appreciated because of market forces, because of individual decisions. The appreciated dollar will probably perform the job of Fed tightening and put a dampener on economic activity despite interest rates remaining low.
Side note: These individual decisions were primarily caused by the ECB's announcement last January to start QE (quantitative easing) in Europe from March 2015 through September 2016 and at the monthly rate of 60Bn Euros. This has the effect of raising government bond prices in Europe and reducing their yields. Today, bond holders stand to earn more interest (or yield) on US government bonds than on their European counterparts. Hence the appreciation of the US dollar.
6) The Fed's policy guidance ought to be interpreted not in a vacuum but in the context of what the futures markets are saying. In this case, not only has the Fed revised its own projections downward, but the futures market is predicting interest rates that are even lower than the Fed's lower projections. Market prices represent the thinking of a large number of economic players who have voted by putting their money where their mouth is. They cannot be taken lightly.
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Getting more speculative,
Side note: These individual decisions were primarily caused by the ECB's announcement last January to start QE (quantitative easing) in Europe from March 2015 through September 2016 and at the monthly rate of 60Bn Euros. This has the effect of raising government bond prices in Europe and reducing their yields. Today, bond holders stand to earn more interest (or yield) on US government bonds than on their European counterparts. Hence the appreciation of the US dollar.
6) The Fed's policy guidance ought to be interpreted not in a vacuum but in the context of what the futures markets are saying. In this case, not only has the Fed revised its own projections downward, but the futures market is predicting interest rates that are even lower than the Fed's lower projections. Market prices represent the thinking of a large number of economic players who have voted by putting their money where their mouth is. They cannot be taken lightly.
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Getting more speculative,
I have read that that one reason that the Fed wants to raise rates sooner than later is because they are afraid of a bubble forming in the US equity markets. (But the Fed's mandate is not to prevent asset bubbles! It's to maintain price stability and full employment.)
I have also read that the Fed wants to raise rates sooner than later so that the next time that there's a recession, there would be room for lowering them. So the thinking is that if rates are low by the time that the next recession arrives, the Fed would have to use other means besides lowering interest rates in order to jump start the economy. But that would be nothing other than QE (quantitative easing)! Again? In what amount? What would that do to global confidence in the US dollar as the world's reserve currency? (Readers may want to do a Google search on "reserve currency" and read further ... E.g. Wikipedia article on reserve currency.)
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