In recent Outlooks and blogs, we have emphasized the importance of Federal Reserve policy in influencing the direction of the U.S. stock market and the relative performance of industry sectors and investment styles. In particular, we have pointed out that in 1994 and again in 2004 the Fed reversed accommodative, anti-recession, low-rate policies and raised rates as economic recoveries gathered steam. In both cases, the Fed rate hikes abruptly halted powerful stock market rallies and led to rotational shifts in investor stock preference. We have also noted the negative impact thus far in 2010 on the prior stock market rallies in China, India, and Brazil as governments and central banks tightened credit in an effort to ward off potential inflation and asset bubbles.
To most Fed watchers, the question not whether the Fed will raise rates but when will they raise rates. For months the Fed has indicated its intention to keep rates low for “an extended period” even though the country has emerged from recession and the recovery has strengthened. At the end of 2009, we expected the Fed to raise rates late in the 2nd quarter or early in the 3rd quarter, by which time we anticipated that job growth would be the catalyst to trigger a change in Fed policy. In April, we subsequently pushed back our expectation to November when the Fed acknowledged economic growth, but stated its concern for the sustainability of the recovery and left in place its “extended period” language in statements regarding their interest rate deliberations. A Wall Street Journal survey of economists, disclosed in a May 12 article, finds that the consensus view in early April was for a hike in November, but now 42% expect the Fed to hold off on tightening until at least 2011. The WSJ attributes their shift in opinion to the European debt crisis, which “underscores the fragility of the global financial system and the risk, however small, of outside shocks derailing the recovery.” As a support to this view, on May 14 Chicago Federal Reserve President Charles Evans stated “I think the risks, obviously, with the global situation make things a little bit more uncertain than we were expecting…so, if anything, I am even more comfortable with my assessment that accommodation continues to be important.”
As the WSJ article points out, low inflation under 2% combines with the European turmoil to provide the Fed with room to keep policy on hold. We presume that the Fed prefers to avoid a rate increase in the politically sensitive months leading up to the national elections in November and thus welcomes this breathing space. On the other hand, the Fed is also painfully aware of the criticism of former Fed Chairman Greenspan and the Fed’s “too little, too late” rate raising policy coming out of the last recession, which permitted the creation of the housing bubble. We will monitor closely and comment on developments at the Fed in future blogs.