Over this past weekend, a group of old people met at a remote mountain resort in the middle of nowhere in the U.S. and talked about money. And judging from the way the financial media treated the event, it may well have been the Greek mythological king of the gods Zeus dancing the polka with Elvis and Michael Jackson, and then announcing a reordering of the universe.
It was actually an annual economic policy meeting in Jackson Hole, Wyoming, in the U.S., where the head of the U.S. central bank (often called the Fed), said, “In light of the continued solid performance of the labor market and our outlook for economic activity and inflation, I believe the case for an increase in the federal funds rate has strengthened in recent months.”
What this means is that the head of the Federal Reserve, Janet Yellen, thinks the Fed will raise its federal funds rate in September, by 0.25 percent. This is the interest rate the U.S. central bank charges to lend money to other U.S. banks, which is currently set at a range of 0.25-0.50 percent.
This matters because what the Fed does is closely watched by investors and other central banks around the world. If the U.S. Fed raises interest rates, many other central banks around the world will likely start doing the same thing. This would lead to higher lending rates for borrowers… and possibly higher returns on cash for depositors. It also matters for financial markets around the world.
That said, one small rate increase isn’t that much. Several more hikes will eventually make bonds and savings account rates more attractive.
Why this meeting’s not worth getting excited about
If this was instead a meeting of, say, weather forecasters, a conclusion similar to Janet Yellen’s pronouncement would be, “It’s going to rain. I’m not sure when, or how much. But I’m pretty sure that it’s going to rain.” It would then be granted breathless there’s-life-on-Mars coverage for days.
There are a few reasons why you shouldn’t pay too much attention to the latest commentary about the Fed…
1. The Fed will shift course if it feels like it. Back in January, we explained that the Fed changes its mind – a lot. In December last year, there was talk of interest rates being raised four times in 2016 (they’ve been raised once, and will probably move up again in September… that’s two, not four). In May and June, the Fed said it would probably raise interest rates. It didn’t.
2. Eventually, interest rates will increase. The real question is what will happen when the Fed starts steadily raising interest rates.
Cutting interest rates is one of the ways that the world’s central banks can help financial markets and economies when they’re in trouble. Reducing interest rates is like a shot of adrenaline to markets. But as you can see in the graph above, interest rates – in Europe and the U.S. at least – have been very low for a very long time.
And at this point, markets are addicted to the adrenaline of low interest rates and quantitative easing (QE). If your lifesaving device doesn’t work because you’re using it every day, it’s not going to be effective when you really need it. And how will this adrenaline-addicted market react when its supply of cheap money is throttled? It could become a very big problem for the global economy.
Plus, we’ve written about how the bond market is broken. That’s because trillions of dollars’ worth of QE and negative interest rates have put the bond market in uncharted territory. As a result, rising interest rates will cause some bond market volatility.
3. You’re better off if you ignore the media black hole. TV producers need to fill air time, especially in the dog days of summer (in the U.S. at least) and analysts need something to analyse and commentators need something to opine about. But there’s a good reason why Warren Buffett doesn’t have any way of following stock quotes on his desk. You’ll be a far better investor if you focus on the big picture – rather than react emotionally to every bit of news that isn’t really news at all… like anything about the Fed.
What the Fed decides matters. The U.S. jobs report will be releasedthis Friday. This will give a big signal of whether the Fed will decide to increase interest rates by 0.25 percent (to 0.5-0.75 percent) when it meets on September 20-21. And before then, markets are going to bounce around a lot.
It’s not going to be like what happened in January, when markets fell after the Fed announced it wouldn’t be raising rates in part because of global market conditions at the time. But markets hate uncertainty – and changes in interest rates can cause a lot of uncertainty. Especially since the world has become addicted to low interest rates.
It also means that the U.S. dollar will probably strengthen. (Money will flow into higher-yielding assets – and a higher interest rate means that some money will move towards the dollar.) That means that other currencies will weaken a bit.
Commodity prices – which are priced in dollars – will also probably suffer. That’s because a stronger dollar means that commodities (if you’re paying in a non-U.S. dollar currency) will be more expensive – so demand will go down.
So brace yourself for lots of talk about the Fed in coming weeks… and prepare to ignore almost all of it.