Three Reasons Why The Fed Might Not Hike Rates This Year

Writer Laurence Peter once said, “An economist is an expert who will know tomorrow why the things he predicted yesterday didn’t happen today.”

This may sound like a joke, but it’s not. Economists are simply not very good at forecasting. In 2008, for example, the consensus from forecasters was that not a single economy would fall into recession in 2009. Instead, we had the greatest global recession in decades.

The Fed is no exception. Just look at their gross domestic product (GDP) forecast over recent years. David Stockman, former economic advisor to Ronald Reagan, points out that economic growth has been consistently weaker than the Fed’s range of expectations known as “central tendency.” Let’s take a look.

The Fed’s Projections Have Been Consistently Wrong

Source: EverBank Research Team, based on analysis of publicly available data from davidstockmanscontracorner.com1

The Fed has been consistently too optimistic on its forecasts. And, it looks like 2015 may be just another year of missing the mark. For the first quarter, the Fed was forecasting growth of 2.6% to 3%, but actual growth came in at -0.2%.2

Given the Fed’s expectation of robust growth at the beginning of the year, most economists were expecting the Fed to hike interest rates in June. Of course, that didn’t happen because the economy has been much weaker than expected.

Despite a disappointing first quarter, the Fed has been consistently telling the market it will likely raise rates at some point this year. Last month, Fed chief Janet Yellen said, “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.”3

And, more recently, she said, “it’s clear from our summary of economic projections that the economy will grow, the labor market will improve.”4 Only she forgot to mention that their projections are almost always wrong. So, we shouldn’t be surprised if the Fed doesn’t keep its promise of hiking rates this year. Let’s take a look at three factors that could force the Fed to delay its first rate hike until next year.

#1) U.S. GDP Growth Has Disappointed

Source: EverBank Research Team, based on analysis of data publicly available from GDP growth above is displayed by quarter.

The U.S. economy is not really booming. The manufacturing sector has been struggling with a strong dollar, which makes U.S.-made goods relatively more expensive overseas. Last quarter, for example, spending on construction, machinery, and research & development fell at a 2% pace – the worst reading for the category since 2009.6

As you can see from the chart above, overall growth has been choppy. Inflation, as measured by the Consumer Price Index (CPI), also remains weak. If we don’t see a significant pick-up in growth, the Fed could very well delay its first rate hike until next year.

#2) Low Liquidity Increases The Risk Of Turmoil In The Bond Market
There’s something fishy going on in the bond market. New regulations implemented since 2009 have prevented banks from making markets in a number of fixed income assets, leaving fewer buyers and sellers of bonds.

As a result, bond holdings are becoming concentrated in the hands of fund managers. This increases the risk that liquidity will vanish in a sell-off. According to the Bank for International Settlements, “the growing size of the asset management industry may have increased the risk of liquidity illusion. Market liquidity seems to be ample in normal times, but vanishes quickly during market stress.”7

Bond yields have already jumped from 1.7% to 2.3% this year. If the Fed raises interest rates, we could see a sharp drop in the price of bonds. That’s a big problem because that kind of volatility could easily spill over into equities, leading to overall market turmoil.

The bottom line is these concerns about a lack of liquidity in the fixed-income markets could sideline any Fed action this year.

#3) Rate Hike May Trigger Crisis In Emerging Markets
Expectations of a rate hike in the U.S. and the resulting U.S. dollar strength have already hurt growth in emerging markets. That’s especially true for countries such as Brazil, India, Indonesia, South Africa and Turkey, which all depend on attracting global capital flows to finance themselves.

The International Monetary Fund (IMF) has recently warned that the Fed’s impending interest rate hike poses a considerable risk to global markets. Mitsuhiro Furusawa, an IMF deputy managing director, recently explained the risk of market disorder: “Once market sentiment shifts – possibly triggered by normalization – yields could sharply increase and capital flows could reverse.”8

The consensus right now is that the Fed will hike rates in September. But, as I showed you today, there are plenty of reasons for the Fed to delay its plan. For investors, this is important because if the Fed doesn’t hike rates, we could see a sharp drop in the U.S. dollar and a recovery in precious metals and other non-dollar assets.

Until the next Daily Pfennig® edition…

Mike Meyer
Vice President
EverBank World Markets, a division of EverBank