What The Fed Needs To Consider Before A Rate Hike [iShares Barclays 20+ Yr Treas.Bond (ETF), ProShares UltraShort Lehman 20+ Yr(ETF)]

Janet-YellenWhen will the Fed raise rates? Matt Tucker highlights some of the common misconceptions people have around when and why the U.S. central bank might make their next move.

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Everyone I talk to, from colleagues to clients, has some interpretation of when and if the Fed should raise short-term rates and start to normalize monetary policy. The International Monetary Fund itself recently shared its take, urging the Fed to delay action. When I speak with investors about this there are two common misconceptions I see in how people anticipate Fed behavior: not remembering who the Fed is and not remembering everything they have said.

Know your governors

Let’s first tackle the “who.” A lot of investors tend to look at the economy and potential Fed action over a very short time horizon. What was the last print on jobs? On GDP? Given that new data, what should the Fed do? What is often lost in this analysis is that the Fed isn’t made up of portfolio managers, traders or investors. They’re academics and historians. Janet Yellen started her career as an assistant professor at Harvard and taught at Berkeley’s Haas School of Business. Stanley Fischer was a professor of economics at MIT. Charles Evans was a professor at the University of Chicago. To be fair most governors have a blend of both academic and private sector experience, but the key point is that the Chairwoman and her colleagues think about the economy in historical terms, over very long time horizons. When they look at today’s Fed funds rate of 0 they think of it in the context of the current easing cycle which began in December of 2008. Since then the Fed has taken a number of unprecedented actions including QE1, QE2, QE3 and Operation Twist. All of these actions have been part of the same monetary policy effort to boost economic growth in the wake of the 2008 financial crisis.

Viewed through that lens, the Fed is unlikely to take action to raise rates until they are highly confident that the economy is on a strong growth path. Anything less would risk undoing the progress made by their actions over the past six years. So when considering the Fed’s next move, we as investors need to take step back and look at the context of market data and the long-term trends.

What was that again?

The second thing that I notice when investors speak about the Fed is that they often hear what they want, but miss the whole message. For example, on May 22 Yellen gave a speech in which she said “If the economy continues to improve as I expect, I think it will be appropriate at some point this year to take the initial step to raise the federal funds rate target and begin the process of normalizing monetary policy.” Pretty clear, right? The Fed will raise rates IF the economy improves. Right after the speech one publication had the headline “Fed chair affirms plans for rate hike this year.” Wait, what? Didn’t they hear the “if”? The writer of this headline, and from my experience many investors, clearly heard the first part of what Yellen said and didn’t pay attention to the second part. This has happened a lot over the past few years; the Fed has repeatedly said that policy normalization will be data dependent, but people often only hear the part about how rates might go up.

A look at the numbers

OK, so the Fed will be data dependent. What does the data tell us? The big challenge the last few years is that the Fed has been overly optimistic in its economic projections. This has led it to believe that a rate hike was around the corner, only to need to hold off when the data falls short. Let’s look at three separate economic measures tracked by the Fed, the levels they expected and what actually occurred.

First, the change in real GDP

Real gross domestic product measures the value of all goods and services produced in the U.S. in a given year and the prices for these goods and services. Median Fed estimates have been consistently higher than reported levels.

Real GDP

Next, PCE Inflation

Personal consumption expenditures measures price fluctuations for goods and services. Inflation in recent years has lagged Fed expectations.

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