The Federal Reserve has scored a victory over the past year by convincing many investors to focus on the entirety of the pace and distance of its rate hike path, which is likely to be slow and shallow, rather than stress over the first hike, which looks likely this year and as early as September. As a result, many investors have continued to venture outward along the risk spectrum, sticking with the stocks, bonds and many other assets they’ve accumulated in reaching for higher returns to escape today’s low-rate climate.
Although many observers were comforted by the market-friendly outcome of last week’s FOMC meeting, the Fed will likely aim to avoid soothing the market too much. After all, when the Fed hikes rates, it endeavors to tighten financial conditions through five major financial channels:
- Stock prices
- Bond yields
- Credit spreads
- Bank lending standards
- Foreign exchange rates
In a recent blog post, Marc Seidner pointed out that the first rate increase in nine years could lead to tighter financial conditions, “with the dollar strengthening, interest rates moving gently higher, the yield curve flattening and the stock market taking a pause or correcting.”
This is quite reasonable; it’s rare for nations to get off the zero bound, and it will be a challenging communications issue for the Fed.
The Fed almost certainly recognizes the risks and will be careful about potentially numbing investors excessively about the first hike. Imagine, for example, what would happen if – because of its constant soothing – the Fed were to hike and financial conditions across those five channels actually loosened rather than tightened. If that were to happen, the U.S. economy could build up a head of steam at a time when the Fed needs to prevent inflation from accelerating and harming the economic expansion. The Fed would then have to ramp up its hikes and calibrate them just right to avoid going too far, a challenging task that is akin to walking a dog on a long leash – it is difficult to control. Investors might then lose confidence in the idea that the path on rates will be slow and shallow.
With the risk of this unfavorable, yet unlikely, scenario in mind, the Fed in the months ahead will likely aim to preserve the progress it has made to date in communicating its data-dependent policy strategy, leaning on economic data to justify a rate hike before long, all the while keeping investors focused on its rate hike path.