Timing of Higher Interest Rates, a New Fed Conundrum

Abstract

Lower oil prices and easier central bank policies outside the U.S. led the market to question the Fed’s timetable for raising interest rates. While both disinflationary and expansionary forces are present, financial markets appear to be focusing on the former, as the latter is still materializing. The net effect may allow the Fed to stay on schedule to raise rates in the second half of 2015. Short-term investors should remain patient through this transitory period.

Introduction

The Federal Reserve’s extraordinary monetary policy accommodations over the last six years resulted in a near zero fed funds rate and growth of its balance sheet by 350% to $4.5 trillion. Today, however, as housing and labor conditions continue to improve and the economy regains its solid footing, the markets and the Fed are looking forward to a new chapter of monetary policy normalization signaled by a higher fed funds rate in the near future. However, rapidly declining energy prices, deflationary concerns outside the U.S., and central banks’ decisions to devalue currencies resulted in high market volatility and doubt in the timing for higher short-term rates in 2015 by the Fed’s consensus forecast.
In the short-term fixed income market, yields rose steadily last Fall in anticipation of the Fed’s pending move. The two-year Treasury note yield rose nearly 0.30% to 0.68% between October and December. In January, however, it tumbled 0.20% to 0.48% after Fed officials added that they could be patient when raising interest rates. Understanding the confluence of factors influencing Fed decisions may help investors stay prepared for more short-term volatility. We will attempt to explain both the positive and negative effects from these recent events on the economy and gain a glimpse into the timing of the Fed’s next move.
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