I know. I know. Everyone’s tired of even thinking about a possible rate hike when the Fed meets on Sept. 20. We’ve been going down the same road, for so long, that it seems almost inconceivable that Janet Yellen and the Fed will actually increase interest rates. And despite Yellen’s Jackson Hole speech stating that the case for a rate increase has “strengthened” in recent months, she also makes it clear that the decision is still on the table. Clearly the mystery won’t be solved until Sept. 20.
But what if the Fed does raise rates? Are your clients’ fixed income portfolios prepared?
The skepticism surrounding a hike isn’t unfounded. After all, the list of events driving global economic uncertainty is long. Brexit. Terrorist attacks in France. The earthquake in Italy. The China “slowdown.” Plus, the U.S. economy is still growing at a sub 2 percent annual clip. And yet, despite all these factors, many analysts are saying this may be the time when rates finally get a hike. The market itself is weighing in: the CME Group 30-Day Fed Funds futures are signaling a 79 percent chance of a 0.25 to 0.50 percent hike at the September meeting. To understand the thinking behind those numbers, let’s take a look at the two main indicators of a hike in interest rates: inflation and GDP.
Inflation on the rise
Here’s the main reason I (and many others) think a rate hike may be in the cards: Inflation is increasing – and increasing more than many people think. Core inflation, which is the consumer price index (or “regular” inflation rate) excluding the food and energy sectors, has been running above the Fed’s target rate of 2 percent for the past nine months.
The recent Bloomberg article “Inflation isn’t dead; it just might not be where you think it is,” highlights the vast discrepancies between rates of inflation for various goods and services. Many of the basic things we need to live have high inflation rates. In the past 20 years, food is up 64 percent, medical care 105 percent, childcare 122 percent, housing 61 percent, and college education a whopping 197 percent. At the same time, many discretionary items have experienced significant deflation. TVs are down 96 percent, toys 67 percent, and wireless service 45 percent. Clearly the current level of inflation is made up of wildly divergent categories of prices, and a change in the mix can quickly drive the overall level of inflation up or down, making defining the “real” inflation challenging indeed.
The second primary metric the Fed looks at when judging whether market conditions warrant Fed interest rate action is “real GDP” (or GDP adjusted for inflation)—a measure that has failed to meet the Fed’s 2 percent annual target for the past three quarters. However, this target threshold has been met or exceeded in six of the last nine quarters. While some see a recent trend of strengthening, just as many see a long slow decline driven by many of the macroeconomic conditions mentioned above, as well as an aging workforce and other demographic factors.
So have the Fed’s “2 and 2” conditions of core inflation and real GDP growth been met? And if they haven’t been met statistically, are they close enough to warrant an increase later this month? Nobody knows—but whatever the decision, now is a good time to consider the impact a “yes” vote may have on your clients’ portfolios.