Even if it were wrapped in shiny paper with a big red bow on it, virtually everyone would have guessed at this year’s Christmas present from the Federal Reserve Board.
For most of us, the rate hike will be the equivalent of coal in our stockings, but for the economists, analysts, stock pickers, pundits, talking heads and other assorted Fed groupies, the rate hike was essential, because it validates their existence. After inaccurately predicting a rate hike throughout 2015, they finally got it right! 
The hike of 25 to 50 basis points in the federal funds rate is an insignificant increase (the Fed’s Board of Governors will raise the interest rate paid on reserves to 0.5% and the Federal Open Market Committee will offer a rate of 0.25% on reverse repurchase agreements), except that it represents the end of an era. ZIRP, or zero-interest-rate policy, has now been replaced with ZIRP+ or maybe Near ZIRP, Almost ZIRP or A-Tad-Above ZIRP. It’s still as close to ZIRP as you can get without being ZIRP.
Questions Raised
Regardless, after 84 months of ZIRP, it’s worth noting that interest rates have changed direction and are now heading up. ZIRP was already old when this blog was started in January 2010. Now what are we going to write about?
That’s not the only question the move raises. Here are a few more:
Now that interest rates are rising, what’s the Fed going to do with $4.5 trillion in long-term bonds and mortgage-backed securities?
That’s a whole lotta bonds to unload. When interest rates increase, bond prices drop, and long-term bonds are affected most – so the demand for them is unlikely to be high. We warned about the risk when the Fed was converting its portfolio to long-term bonds back in April 2014. Hopefully, Fed Chair Janet Yellen has an e-Bay account.
It’s worth noting that, since the Fed’s decision to raise rates was announced, short-term rates have been moving higher, but long-term rates have been moving lower (and will likely continue to do so).
But not to worry. As the Fed’s policy statement explains, “The Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction, and it anticipates doing so until normalization of the level of the federal funds rate is well under way. This policy, by keeping the Committee’s holdings of longer-term securities at sizable levels, should help maintain accommodative financial conditions.”
Nothing like a $4.5 trillion accommodation.
How will the Fed go about raising interest rates?
While the Fed may appear to have God-like powers (at least former Chair Ben Bernanke seemed to), it can’t just command things to happen.
“In the past,” The Wall Street Journal noted, “the Fed would sell short-term Treasurys, soaking up bank reserves. That would put pressure on banks to fund their operations, and drive up the fed-funds rate as borrowing demand rose. In other words, the Fed decreased the supply of bank reserves to change a price, the fed-funds rate. But the Fed no longer holds any short-term Treasurys to sell. Normally, either the supply or demand for something must change in order to change a price.”
What if the Fed needs to reverse direction?
In the same week that the Fed was increasing rates due to the allegedly rosy economic outlook, the Philadelphia Fed was announcing that its manufacturing index had fallen to an abysmal -5.9. Any reading above zero indicates improving conditions and economists expected a reading of 1. The index for new orders fell a whopping six points to -9.5. Those are recession-level numbers.
As MarketWatch noted, “Manufacturing more generally has been weighed down by the strength of the U.S. dollar, tepid foreign demand and the collapse in oil prices.”
Increasing rates will make the dollar even stronger, reducing foreign demand, while also reducing the price of oil. Way to go Fed!
It’s likely that the economy is slowing down from its already slow growth, which would mark the first time since 1967 that the Fed has raised rates during a slowing economy. While the U.S. Bureau of Economic Analysis revised its estimate of GDP growth for the third quarter up to 2.1% from 1.5%, that’s still well below the 3.3% post-World War II average. We can hardly wait to hear what the GDP results for the fourth quarter will be, but early results for the important Christmas shopping season are not encouraging.
It’s worth noting that the Fed has never predicted a recession.
With ZIRP+, at least the Fed can reduce interest rates if it needs to. Not that going back to ZIRP will have much impact, given all of the tightening taking place in other parts of the world.
Who writes the Fed’s policy statements?
Download the Fed’s latest policy statement and challenge yourself to stay awake while you read it. You’ll find, for example, that “the actual path of the federal funds rate will depend on the economic outlook as informed by incoming data.”
Well, no kidding. And I thought they just made stuff up. Pretty much the whole statement is CYA.
Do Fed members still believe in the Phillips curve?
The Phillips curve is based on the belief that inflation rises when unemployment drops, which is what the Fed is hanging its already tarnished reputation on in predicting that inflation will rise to 2%, meeting the Fed’s ZIRP goal and enabling the Fed to claim, “Mission Accomplished,” even though it hasn’t been.
Periods of stagflation, first in the United Kingdom as early as 1965 and then in the U.S. in the 1970s, proved the Phillips curve to be inaccurate. During periods of stagflation, as the name implies, the economy is stagnant, resulting in high unemployment, but the rate of inflation is also high.
Following a discredited economic theory is apparently more palatable to the Fed than admitting that buying trillions of dollars’ worth of bonds had no noticeable impact on the inflation rate. After all, as Keynesians, the Fed members are accustomed to following discredited economic theories.
What if those who are predicting that bad things will happen are right?
A few examples of the financial Armageddon that allegedly will befall us as a result of the 25 basis point interest rate increase:
David Stockman, recalling the market crash and Great Depression that followed, wrote: “I believe the world is at the greatest financial market inflection point since 1929.” He added that, “Central banks are pushing on a string. They can’t generate more credit no matter how hard they try because most of the world is at what I call “peak debt.” That’s the point where households, companies, governments and even countries are tapped out. They’re stuck with such monumental debt burdens that they can’t service any additional debt no matter what the interest rate — even zero or below.”
According to the International Business Times, unicorns will be forced to go public: “It’s been cheap to borrow to fund their own growth, and they’ve been able to pull fresh capital from hedge funds, private trusts and other investors willing to take on more risk in exchange for yields beyond what’s been available in the fixed-income markets. But as government issues and bonds become more attractive under Fed Chair Janet Yellen’s move to gradually boost rates, unicorns may be forced into the public markets to fund growth.”
Zerohedge, meanwhile, is not optimistic about the impact of Fed action and wrote: “We will turn sellers of risk in early ’16 because rising rates and falling profits are ultimately not a good combination for asset prices.”
Elsewhere on Zerohedge, SocGen’s Albert Edwards wrote: “… rather than presiding over a sustainable recovery, as the myopic Fed would have us believe, we are unfortunately sitting on yet another recession-inducing, debt time bomb waiting to blow. … Outright deflation beckons in the next recession as a direct result of the Fed’s negligently loose money policies and hence it will fail to meet their explicit dual mandate, let alone its ‘unwritten’ financial stability target. I believe the Yellen Fed will soon be treated with the same contempt the Greenspan Fed was in the aftermath of the 2008 financial crisis. And they will deserve it.”
So what can we expect? It’s too early to tell, but we can be pretty certain that record economic growth is not going to happen anytime soo