As we have written previously (see story), interest rate cycles can be broken into four phases:
In phase 1, the Federal Reserve is transitioning from a low interest rate environment to gradual tightening. This happens as the economy starts to improve and inflation begins to rise. Think 2004 as Greenspan started to raise interest rates in quarter point increments from extremely low levels. In this phase P/E multiples and the bond market begin to peak with the historical mean return on stocks around 10%.
In phase 2, monetary policy is now much more restrictive and well into tightening mode. The economy is doing quite well and inflation is running much higher. Commodity prices begin to climb steadily and profit margins are beginning to get squeezed with rising input costs. Think 2006 and 2007 as interest rates rose to 5%. This is a deadly combo for stocks and the economy, and typically the time when investors should start worrying. (Note: We’re not yet in this phase with low economic growth and inflation.) The historical mean return for stocks in this phase is around 2.5%.
In phase 3, policy is tight, interest rates have peaked and may now be rolling over. The stock market has corrected and the economy is either in or very near recession. Think 2008. In this phase, the historical mean return of stocks is -9%.
In phase 4, monetary policy is loose once again, the economy is in recovery mode, and inflation is running low. This is the best phase for stocks with a mean return around 23%.
Given the above, it is clear that we are well into phase 4 with the most important variable being how long this phase will last before the Federal Reserve moves into gradual tightening mode.
Given their current assessment of economic conditions, Yellen said they will likely keep rates low for a “considerable time” even after QE3 ends to help meet their stated goals. Furthermore, once those goals are met, they still believe economic conditions warrant lower than normal levels of interest “for some time”.
Here is Yellen again (emphasis mine):
In determining how long to maintain the current 0 to ¼ percent target range for the federal funds rate, the Committee will assess progress—both realized and expected—toward its objectives of maximum employment and 2 percent inflation. This broad assessment will not hinge on any one or two indicators, but will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial developments. Based on its current assessment of these factors, the Committee anticipates that it likely will be appropriate to maintain the current target range for the federal funds rate, for a considerable time after the asset purchase program ends, especially if projected inflation continues to run below the Committee’s 2 percent longer-run goal, and longer-term inflation expectations remain well anchored. Further, once we begin to remove policy accommodation, it’s the Committee’s current assessment that, even after employment and inflation are near mandate-consistent levels, economic conditions may, for some time, warrant keeping the target federal funds rate below levels the Committee views as normal in the longer run.
Since we have already seen nearly six years of ultra-low rates, how much longer can they last?