When will the Fed raise interest rates? If you ask investors, the answer is “Not this year”. Bets have been placed on bond futures which imply that the Fed Funds Rate will be no higher than a quarter of a percent at the end of the year – hardly any rise at all.
But if you ask the Fed, it’s going to come soon. Why doesn’t anyone believe them?
We’re still in the regime of the “liquidity trap” where economic stimulus simply doesn’t happen at lower rates because there’s already too much cash out there. More doesn’t do a thing except concentrate in the hands of those who already have a lot.
This doesn’t mean that there aren’t other effects which drive the economy, however. Chief among these is the foreign exchange rate, or the value of the US Dollar beyond our borders. A stronger US Dollar makes our goods more expensive when the price is converted to Euros, Reals, Yuan, or Yen. Manufacturers start sourcing more parts away from the US, where everything seems cheaper by comparison.
A higher interest rate makes Dollars harder to get, which raises their value. The strong run in the Dollar through 2014 resulted in the Euro falling an amazing 22% versus the greenback over a one year period:
Everything we sell to Europe jumped in price by 22% during this period. And since oil is priced in US Dollars, a good part of the collapse in oil prices in $/bbl was about the strength of the Dollar as much as the weakness of oil.
But the Fed hasn’t raised rates yet, and the US Dollar isn’t harder to get. The world is awash in our paper. So what’s driving the increase?
The short answer is nothing. This is shown by a collapse in the value of the buck that came very suddenly on the back end of a very weak retail sales report for April. There was no net increase at all in retail sales, a bit lower than the expected weak 0.2%. It was nothing but the straw that broke the camel’s back, causing a massive sell-off of the Dollar and general speculation that the Fed isn’t going to raise rates in the near future.
What’s funny about this is that the Fed has made their intentions pretty clear. David Altig, research head at the Federal Reserve Bank of Atlanta, said, a rise “feels most probable somewhere in the late summer than the early summer, but early summer is not out of the question.” How big? “Even after we move, we don’t expect to move all that quickly. We’re going to be data dependent.”
That probably means a small, token rise – but it’s a rise all the same. No matter what the market says, the Fed is definitely interested in raising rates.
Why on earth would anyone bet against the Fed?
The short answer is the market believes it knows better what is coming and the Fed isn’t going to do a thing this summer. This should keep the US Dollar on a downward trajectory against the Euro and, gradually, raise oil prices. That may have the effect of cooling off the economy more than any rise in interest rates, too. It also might employ more people as manufacturing gets a break and the oil industry starts to drill new wells again.
The delicate balance that has to be kept is largely outside of the Fed’s control no matter what. Why do we care what interest rates are, then?
Oh, yes. The rest of us have to pay interest on the money we borrow from banks. Low rates benefit everyone as long as inflation remains low, and in an economy that still needs more work the Fed is going to do its best to keep the stimulus coming. The problem, however, is that it is losing a little more control every day – and the market is now betting that it has more power than the Fed.
Who will win? We’ll find out this summer, if the rhetoric from the Fed is accurate.