Federal Reserve Chairwoman Janet Yellen, shown at a Washington conference earlier this month. PHOTO: CHIP SOMODEVILLA/GETTY IMAGES
Federal Reserve officials were divided at their last policy meeting on whether they would be ready by June to begin raising short-term interest rates.
While several officials thought June would be the right time to raise rates, others believed energy-price declines and a strong U.S. dollar would weigh on inflation and warrant keeping rates near zero, where they have been since December 2008, according to minutes of the Fed’s March 17-18 policy meeting, released Wednesday with the usual three-week lag.
The central bank excised an assurance from its policy statement at that meeting that it would be patient before raising rates. The move effectively opened the door to rate increases by June. The minutes showed the divisions about actually moving.
“Several participants judged that the economic data and outlook were likely to warrant beginning normalization at the June meeting,” the minutes said. “However, others anticipated that the effects of energy price declines and the dollar’s appreciation would continue to weigh on inflation in the near term, suggesting that conditions likely would not be appropriate to begin raising rates until later in the year, and a couple of participants suggested that the economic outlook likely would not call for liftoff until 2016.”
Since that gathering, several economic data releases have suggested the economy has started off 2015 slowly, most notably a release last week by the U.S. Labor Department showing hiring downshifted in March.
“Data has surprised to the downside,” William Dudley, president of the Federal Reserve Bank of New York, said in an interview with Reuters on Wednesday. “It’s reasonable to think the bar is higher” to the central bank acting in June.
Officials expressed some concerns about the economic outlook even before this latest batch of data. This included several references to a strong dollar, which tends to undermine exports by raising the cost of goods sold overseas, and holds down inflation by lowering the cost of imported goods.
“Several participants noted that the dollar’s further appreciation over the intermeeting period was likely to restrain U.S. net exports and economic growth for a time,” the minutes said. “A few participants suggested that accommodative policy actions by a number of foreign central banks could lead to a further appreciation of the dollar, but another noted that such actions had also strengthened the outlook for growth abroad, which would bolster U.S. exports.”
The Fed also took an important operational step at the meeting aimed at strengthening its hand when it decides to start raising rates. Officials decided they would be willing to temporarily lift a self-imposed cap on a new instrument known as “overnight reverse repos,” which they plan to use when raising rates.
Using these instruments, the Fed trades with money-market funds and other nonbank financial institutions, paying them interest in return for overnight credit. Wary of using the instrument aggressively, the Fed had set a daily cap on reverse repos at $300 billion. But that could make it harder to manage interest rates and they decided the cap might need to be “temporary elevated” to help manage interest rates.
They had discussed the idea of temporarily lifting the $300 billion cap at their January meeting, minutes of that meeting showed.
Via – The Wall Street Journal
How does this affect investors?
The last thing that the Fed wants to do is put additional obstacles in the way of an economic recovery that many Fed officials already see as fragile. Higher interest rates affect many facets of the economy, but at a basic level they lead to increased borrowing costs, increased savings, decreased spending, and lower expected returns on investments, each of which could potentially derail an economic recovery. The effects of rising interest rates are bad for capital intensive stock market sectors because they lead to higher expenses and borrowing costs for many companies, which in turn lead to lower earnings and cash flow, which decreases the value of a company’s stock. Historically, domestic stocks have underperformed during rising rate environments, but the magnitude of underperformance decreases during periods when interest rates are increased slowly. While we still think that the Fed will begin raising interest rates in 2015, any increases are likely to come later in the year and be smaller than previously expected. Market volatility will remain elevated as long as the Fed remains skeptical that the recovery has gained enough traction to warrant raising rates, and there could be a pull back when the Fed finally does take action. For now, bad economic news will likely be good news for stocks, as any downside surprises will pressure the Fed to remain patient, delay the first interest rate hike, and maintain its accommodative policies.