What To Expect From The Fed December Rate Increase?

Welcome to the Investors Trading Academy event of the week. Each week our staff of analysts and educators tries to provide you a better understanding of a major market event scheduled soon and that have an effect on the global markets. Nearly seven years ago the Fed put its benchmark interest rate close to zero as a way to bolster the economy. And for months now, officials have said they might raise rates by the end of 2015. Recent statements underscore an intention to act at their final meeting of the year, in December. It’s a “liftoff” – to use the Fed’s own term – that’s getting the kind of attention that space aficionados once lavished on NASA rockets. Fed officials left rates unchanged after meeting in October, but when they do make their announcement, it will have lasting consequences. The last time the Fed raised interest rates, in June 2006. The forthcoming decision of the Federal Reserve on interest rates is a humbling example. Consider that after seven years of virtually zero percent short-term interest rates, the Federal Open Market Committee is almost universally expected to raise rates slightly at its Dec. 15-16 meeting. What this means for the markets isn’t clear, however. We can’t rely on historical precedent. The last time rates rose after remaining very low for so long was in 1941. That was a long time ago, and when there has been only one previous example, in very different circumstances, historical statistics won’t prove much of anything. There are other ways of analyzing the likely effects of the Fed actions, but all have severe limitations. First, logic tells us that if short-term Treasury rates rise, low-risk Treasury bills may become more attractive in comparison with riskier alternatives like stocks. That suggests that the stock market should weaken because people will become even more wary than they may be right now about share prices, which have tripled since 2009. Home prices should weaken too, because rising interest rates can be expected to make mortgages more expensive. In other words, this line of thinking is quite negative about the general effect of a rate increase on market prices. There is another way to look at this, though. If the Fed raises rates in December it could be seen as good news because the Fed wouldn’t take that action unless it viewed the economy as relatively strong. That could buoy market prices. This approach immediately leads to further complications. Good news about the economy might be bad news about inflation, which tends to rise when economic growth picks up. On the other hand, if inflation rises, even if the Fed raises rates slightly, the real, or inflation-corrected, interest rate might actually be lower, not higher. By Barry Norman, Investors Trading Academy - ITA