Will Interest Rates Rise In 2015?

Crystal BallBackground.  Quantitative Easing or “QE” is a process whereby the Fed purchases large quantities of long-term securities held by big banks. The Fed prints money to make these asset purchases.  By reducing the supply of these securities for other investors, the price goes up.  When the price of the bonds goes up, their yield goes down.  This means that for large companies and municipalities who depend upon the sale of bonds for the financing of projects, their borrower costs go down. 

Since mortgage interest rates track the long term T-Bill rates, as QE keeps these rates low, it also keeps mortgage interest rates low.  The goal of QE was to keep long term interest rates low and release more money into the marketplace, thereby increasing economic activity for households and businesses.[1]

The Federal Reserve first began a policy of “Quantitative Easing” shortly after the credit markets crashed following the Bear Stearns collapse and the Lehman bankruptcy in the fall of 2008.  QE2 occurred in 2010; QE3 was initiated in 2011. In its third iteration, QE3, the Fed was buying $45 billion in treasury bills (“T-Bills”) and $40 billion of mortgage-backed securities a month.

When interest rates went down – which they did – the hope was that the construction and housing industries would rebound, businesses would increase capital investment, employment would increase, and household balance sheets would improve.  The Fed’s mantra at the time was that QE and low interest rates would continue until unemployment, which exceeded 10% at the time, came down to seven percent.[2]

However, after three shots at QE, there is no broad consensus that it worked.[3] Although the idea behind QE was that pumping money into the economy would stimulate investment, employment, and housing, it didn’t really happen.  The recession has been deeper and longer than anyone anticipated; recovery has been slower. We’ll never know if the U.S. economy would have been any worse without QE.

In October 2013, the Fed began slowly taking its foot off the QE pedal – a process called “tapering.”  In October 2014 it had officially ended.  According to Bloomberg Quick Take, “…even after the taper’s end the Fed continued to pump support into the economy the old-fashioned way, by holding its interest rates near zero.

Interest Rates and Inflation.  Now that QE is officially over, the new topic du jour is interest rates – when will the Fed begin returning them to normal levels?  The conventional wisdom based upon prior statements going back to Ben Bernanke, and now with Janet Yellen, the new Fed Chair, has been that rates will not likely begin to rise before mid-year in 2015.

The fear is that inflation, which the Fed wants to see at 2.00%, has remained stubbornly low.  For most folks, the idea of inflation in any amount sounds bad, since it erodes one’s purchasing power. But the worry is that if inflation gets too low, i.e. close to zero, we could lapse into “deflation,” where prices fall.  When that happens, economic theory holds that people reduce spending, as they wait for prices to fall further.  Essentially this happened with real estate circa 2007 – 2012.  While there were many other reasons for falling home prices, it was a buyer’s market back then, and many potential purchasers remained on the sidelines waiting for values to hit bottom.

The school of thought that some inflation is good, is based upon the idea that with more employment, workers can move up and demand higher wages.  That then is reflected in the cost of goods, which also tick up; ergo, you have inflation.[4]

Good News, Bad News.  The last three months of 2014 have brought us very good financial news, and emboldened some at the Fed to think about raising rates sooner rather than later.  Here are some of the highlights of 4Q 2014:    

  • Notwithstanding the voices of doom and gloom which predicted that interest rates would spike when tapering ended, QE is over and interest rates have actually continued to drop a bit. [See Bankrate table here.]  
  • The Wall Street Journal reported here that the December 5, 2014 jobs report issued by the Bureau of Labor Statistics showed that “…U.S. employers added 321,000 jobs last month—the best monthly gain in almost three years–while the unemployment rate held steady at 5.8%….”
  • In addition, as virtually everyone who drives a car knows [with the possible exception of Tesla owners], the oil market has tanked…pardon the pun.  This is due in large part to the oil glut resulting from the fracking revolution going on in the U.S.[5]  Prices at the pump and for home heating oil have plummeted. This has translated into increased consumer spending – all good news to everyone but Iran, OPEC, Venezuela, and Mr. Putin. On the other hand, lower prices hold down inflation, which is already lower than the Fed’s 2.0% goal.  This fact supports keeping the status quo until inflation gets closer to 2.0%.
  • Then there is the issue of the strong U.S. dollar.  While it enables us to buy imports more cheaply, it makes exports more expensive, as it costs other countries more to purchase our goods.  This directly affects U.S. manufacturing, employment and GDP.[6]  To some, a strong U.S. dollar puts a damper on GDP and is a bad thing; to others, it is a reflection of international confidence in our country, and therefore a good thing.
  • On October 30, 2014, the Commerce Department reported a 3.5% growth in GDP for 3Q 2014.  As reported by Bloomberg here: “Gross domestic product grew at a 3.5 percent annualized rate in the three months ended September after a 4.6 percent gain in the second quarter, Commerce Department figures showed today in Washington. It marked the strongest back-to-back readings since the last six months of 2003.” [Italics mine.]

However, notwithstanding the recent encouraging financial news, the doves at the Fed believe we still have a very fragile economy and do not want to normalize interest rates too soon. A recent statement by former Fed Chair Alan Greenspan [who has had to eat some very sizeable portions of crow for admittedly failing to heed the early warning signs of the impending collapse of the financial real estate and markets in 2007-2008] puts a fine point on the continuing problems with the country’s economy today.  According to a December 31 report on bloomberg.com here:

Greenspan said the economy won’t fully recover until American companies invest more in productive assets and the housing market bounces back[Italics mine.]

“Almost all of the weakness in the last four, five, six years has been in long-lived investments” in capital goods and real estate, Greenspan said. “Until these pick up, we’re not going to get the kind of vibrant growth that everyone is hoping for.” [Italics mine.]

Mr. Greenspan is correct – this time.  We’re not out of the woods yet.  Even though interest rates remain at historically low levels, sales of pre-owned homes were better in 2013 than 2014 by approximately 1.7% according to Forbes magazine, using statistics provided by the National Association of REALTORS®.

And despite predictions and reports to the contrary, in some parts of the country – including Oregon – there is still a glut of foreclosures, displacing families, and keeping available housing off the market for resale.[7]

Currently, there are more doves than hawks at the Fed.  In its last meeting of the year, on December 17, 2014, the doves carried the day.  The Committee report[8] stated that:

Based on its current assessment, the Committee judges that it can be patient in beginning to normalize the stance of monetary policy. The Committee sees this guidance as consistent with its previous statement that it likely will be appropriate to maintain the 0 to ¼ percent target range for the federal funds rate[9] for a considerable time following the end of its asset purchase program in October, especially if projected inflation continues to run below the Committee’s 2 percent longer-run goal, and provided that longer–term inflation expectations remain well anchored. [Note: Highlights mine.  The “considerable time” language was in the earlier Fed statement from October 29; the reference to being “patient” was new as of the December 17 report.]

The Take-Away.  So by including a statement of intent to remain “patient,” it is my belief the Fed’s doves are, in fact, saying that they are not going to rely upon on a few recent months of good news, and resume normalization of interest rates, say in 2Q 2015. In other words, they are still looking to mid-year 2015 before changing policy. Of course, as a hedge to avoid over-committing, the Fed added the following in its December 17 report:

However, if incoming information indicates faster progress toward the Committee’s employment and inflation objectives than the Committee now expects, then increases in the target range for the federal funds rate are likely to occur sooner than currently anticipated. Conversely, if progress proves slower than expected, then increases in the target range are likely to occur later than currently anticipated.  [Highlights mine.]

Lastly, there is one more factor that – though unstated in the FOMC report – has to be on Ms. Yellen’s mind: Five years of cheap money, even though it hasn’t been the boon to housing it should have been, can spoil anyone.  There are young people just now thinking of entering the housing marketplace; there are empty nesters thinking about selling, and perhaps downsizing.  After half a decade of historically low interest rates, there has to be a concern by policy makers that increasing the cost of money could be a deal killer, depressing new construction and housing sales even more. ~PCQ

[1] For a good discussion of whether it worked, see link from the BBC here.

[2] For details, see MoneyNews article here.

[3] For a cynical, but very funny explanation of Quantitative Easing, see cartoon here.

[4] For a simplified discussion of the  pros and  cons of inflation, see marketplace.org link here. For a contrary view, see Fortune link here.

[5] How long this will continue is a matter of some debate, however.

[6] Investopedia defines GDP as follows: The gross domestic product (GDP) is one the primary indicators used to gauge the health of a country’s economy. It represents the total dollar value of all goods and services produced over a specific time period – you can think of it as the size of the economy.

[7] Foreclosures actually increased in 2014 over 2013.

[8] The Federal Open Market Committee (FOMC) consists of twelve members.  They include the seven members of the Board of Governors of the Federal Reserve System; the president of the Federal Reserve Bank of New York; and four of the remaining eleven Reserve Bank presidents, who serve one-year terms on a rotating basis.

[9] Investopedia defines the fed funds rate as: The interest rate at which a depository institution lends funds maintained at the Federal Reserve to another depository institution overnight. The federal funds rate is generally only applicable to the most creditworthy institutions when they borrow and lend overnight funds to each other. The federal funds rate is one of the most influential interest rates in the U.S. economy, since it affects monetary and financial conditions, which in turn have a bearing on key aspects of the broad economy including employment, growth and inflation. The Federal Open Market Committee (FOMC), which is the Federal Reserve’s primary monetary policymaking body, telegraphs its desired target for the federal funds rate through open market operations. Also known as the “fed funds rate”.