When the Federal Reserve’s top policymakers met in Washington this week, they decided to raise interest rates for the fifth time since the Great Recession, removing some of the crisis-era stimulus from the economy.
Low interest rates are thought to fuel economic activity by making it cheaper for borrowers to take out loans on everything from mortgages to car loans and small business financing. As a side effect, near-zero rates have also boosted the stock market by making it nearly impossible to earn a meaningful return on lower-risk investments.
But now that the Fed is unwinding its stimulative policies, will the central bank also sap some steam out of the ongoing bull market for equities?
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Not likely, Wall Street watchers say. And there are two key reasons why.
It takes a surprise to move the market. First, the Fed’s interest rate hikes have been widely expected by the market, and as a result, only a surprise outside of the norm would jolt investors at this point.
Since December 2016, Fed officials forecast they would raise interest rates three times or more this year, and they’ve stayed true to that prediction, raising rates at their March, June and December meetings.
That’s not always the case, though. In other years, there have been more surprises.
“Interestingly, since rate hikes started, 2017 is the first year that the Fed did what they projected they would do,” Michael Gregory, deputy chief economist for BMO Capital Markets writes in a note to clients. He points out that in previous Decembers, the Fed projected it would raise rates four times in 2015, but then followed through with one such hike. Officials also projected four increases in 2016, but again only raised rates once that year.
Perhaps that’s why the market is currently pricing in only two rate hikes next year, even though the latest median projection from Fed officials calls for three moves in 2018. Investors don’t fully believe the Fed just yet.
Lindsey Piegza, chief economist for Stifel Fixed Income, for example, thinks the central bank may find it difficult to justify even one rate hike in 2018, let alone three as long as inflation remains low. Jerome Powell, who has served on the Fed’s Board of Governors since 2012 is set to succeed Janet Yellen as chair next year, and his approach to policy may vary slightly from hers, Piegza says.
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“The lack of meaningful wage growth and still-low readings of core inflation could create a hurdle for additional rate hikes, particularly with Powell at the helm,” Piegza writes in a note to clients. “Powell has argued in favor of adjusting monetary policy based on realized improvement, as opposed to Chair Yellen, who has suggested time and time again monetary policy must anticipate changes in growth and inflation.”
However, others — like Gregory — think inflation could pick up more than expected next year, especially if new tax legislation lowers corporate tax rates, unemployment remains low and the economy continues growing at a solid pace.
“We judge the Fed will not only live up to what it projects, but that the net risks now tilt a bit to more moves,” he says.
Which leads to another reason why rate hikes are unlikely to stop the current bull market in 2018: The U.S. economy is strong, and globally, other major economies are strengthening.
Why the Fed is hiking rates now. “I think a lot of investors think higher interest rates spell trouble for equity markets, but the important thing for investors is not that the Fed is raising interest rates, but why the Fed is raising interest rates,” says Scott Clemons, chief investment strategist for Brown Brothers Harriman. “If the Fed raises interest rates because the economy is firing on all cylinders — that’s good for investors and that’s good for equities.”
Indeed, in a press conference Wednesday, Yellen said that the “ongoing strength of the economy” was behind the central bank’s reason to continue raising rates.
When asked about the recent bull market for stocks, she noted that economists are paying attention to historically high valuations of stocks right now, but also that low interest rates have in part, supported those high valuations.
“Economists are not great at knowing what appropriate valuations are,” she says. “We don’t have a terrific record, and the fact that those valuations are high doesn’t mean that they are necessarily overvalued.”
Would a sudden correction in the stock market raise risks to financial stability, the way the last financial crisis did?
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“There’s nothing flashing red there or possibly even orange,” Yellen says.
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Why the Fed Won’t Slow Down Stocks originally appeared on usnews.com
