The Federal Reserve last raised rates in 2006, cutting them down to zero in 2008 at the height of the financial crisis. Rates have remained there ever since, as CD savers will attest. The Fed raised rates slightly at its December meeting, likely just the first of several increases. Many fear the impact of higher interest rates, but we believe there is much room to raise rates further before the economy is harmed.
The Fed’s primary purpose is to promote economic growth and stability through its “dual mandate” of full employment and low inflation, which the Fed has established to mean 2% inflation. Inflation has remained below the Fed’s 2% goal for 3 1/2 years and output growth has been slow to recover in the recession’s aftermath. These two factors, compounded by global economic uncertainties and world events, have given the Fed ample opportunity to take its time in raising rates. In fairness, there seems to have been little downside to this foot-dragging and perhaps the economy is better off. That’s the wisdom of making an informed decision as a group, the Federal Open Market Committee, rather than just one person.
Inflation may start to edge up once certain powerful factors cease to have incremental impact. The drastic decline in energy costs held back official measures of inflation, and we haven’t yet felt the full impact on overall prices since energy and transportation are imbedded in the cost of all goods. Prices outside of energy have maintained their steady rise at just under 2%.
Sliding energy prices have had many other impacts. Industrial production has been weighed down by weak orders for oil and gas equipment. Despite a falling unemployment rate, jobs in energy and mining, manufacturing, transportation, and warehousing have been in a flat-to-down trend this year. These tend to be higher paying jobs so their relative softness has hurt overall wage growth. Despite this softness, wages were up 2.3% year over year in November, a bit faster than the recent trend. This may have caught the Fed’s attention, signaling that labor markets are starting to heat up. Raising interest rates increases the potential length of the economic recovery by keeping it from overheating.
Falling energy prices were also expected to boost spending as consumers have more money in their pockets. The results aren’t particularly impressive in this regard, and may even appear to be non-existent. Personal income growth has been stronger than consumer spending growth for six straight months. As a result, personal savings rates have improved. An economist’s take would be that consumers don’t yet believe that energy costs will remain low for the long haul and are pocketing, rather than spending, what they perceive to be only temporary savings.
Manufacturing is not only being affected by weak demand for oil and gas equipment, but also by slow overseas economies and competition from foreign companies with a price advantage due to the strong U.S. dollar.
What remains to be seen is how inflation will behave once the dollar and oil prices reach the anniversary of their dramatic shifts. That is to say, will falling unemployment create a scarcity of labor and drive up wages just as the deflationary impact of the strong dollar and plummeting energy prices abate? That is the cost-push inflation curve the Fed is trying to stay in front of by raising rates now rather than waiting to see what happens. Inflation can get out of control once it becomes imbedded in expectations.
Excerpted from Provident Investment Management’s January investment comments newsletter