Raising Interest Rates: Will the Federal Reserve Get it Right?

With the economy recovered from the Great Recession, the Federal Reserve (the Fed) has focused on returning short-term interest rates to historical norms. So far, things have gone pretty well—but there’s always the potential for the Fed to go too far, too fast, which could hasten another recession.

It’s happened before, notes Kathy Jones, Schwab senior vice president and chief fixed income strategist—although “the central bank’s overreach was apparent only in hindsight.” That’s what makes predicting the outcome of the Fed’s strategy so tricky, Kathy says. How likely is it to overstep? How will we know? Let’s take a look at the Fed’s role and three indicators that could signal where policy is headed.

The Fed’s charge

The Fed sets monetary policy—in other words, it manages the money supply by controlling short-term interest rates and influencing the cost and availability of credit.

The Fed has multiple tools to influence monetary policy, one of which is the federal funds rate—the interest rate at which depository institutions, such as banks and credit unions, lend excess balances to one another on an overnight basis. An increase in the federal funds rate can affect everything from the yield on savings accounts to mortgage rates to the stock market.

How far we’ve come

In response to the Great Recession, the Fed reduced the federal funds rate from 5.25% in September 2007 to a range of 0–0.25% by December 2008. (The Fed also took a number of other measures, such as quantitative easing, to help stimulate the economy.) Gradually, the economy began to recover.

In December 2015, with conditions greatly improved, the Fed began returning to more traditional monetary policy measures that aim to maximize employment, stabilize prices and moderate long-term interest rates. Since then, the Fed has raised the federal funds rate eight times—once in 2015; once in 2016; three times in 2017; and, thus far, three times in 2018—each time a quarter percent. And it has signaled the likelihood of one more rate hike this year, with more to come in 2019.

Will the Fed go too far, or move too fast? “While it’s nearly impossible to tell in advance—that’s a question Fed policymakers themselves struggle with,” Kathy explains, “there are a few indicators that can help investors gauge whether the Fed is near the end of the cycle or likely to overshoot, and whether it might be time to make portfolio changes to manage potential risk.

• Market indicator #1: A flattening yield curve
  When the yields on the three-month Treasury bill and the 10-year Treasury bond start to converge, the yield curve is said to be flattening—and that’s happening now. Since December 2015, the difference between short-term and long-term interest rates has narrowed from 2.00% to 0.86%. While the yield on the 10-year bond has risen recently, several more quarter-point rate hikes by the Fed have the potential to raise short-term rates to an equivalent level. Historically, this convergence has signaled a peak in bond yields.
• Market indicator #2: A decline in inflation expectations
  As the Fed raises rates, borrowing costs rise, economic growth slows, and investors’ expectations for future inflation may soften, too. One way to judge inflation expectations is to compare the yield of a Treasury Inflation-Protected Security (TIPS) with the yield of a comparable-maturity traditional Treasury security. Because TIPS have a provision to increase their coupon payments as inflation rises, they generally offer lower yields than traditional Treasuries, which have fixed interest rates. The difference between the two yields—called the breakeven rate—represents the rate of inflation that investors expect. So far this year, the 10-year breakeven rate has been fairly steady; it currently sits just under its YTD high of 2.18%. If it begins to decline, it could be a signal that bond yields have peaked and that the Fed should be near the end of its tightening cycle.  
• Market indicator #3: Tightening credit conditions
  Another indication of the end of the economic cycle is tightening credit conditions—when loans become more expensive and harder to get. “To date,” according to Kathy, “there are few signs of tightening credit conditions. Current yield spreads indicate that neither banks nor investors are very concerned about the risk of default. And loans for sub-investment-grade borrowers are still readily available.”

What you can do now

“At this point,” says Kathy, “we see only one indicator—the flattening yield curve—that could be signaling an eventual end to the rate-hiking cycle.” But once all three signals have flashed, it’s quite possible that bond yields will have already begun to decline. Schwab advises investors to keep their eyes on market changes and consider the following actions:    

• Maintain short- to intermediate-term (two to five years) duration in your bond portfolio and consider floating rate notes as a way to increase income as short-term interest rates rise.
• Put short-term returns in perspective: Despite lackluster performance this year, returns have been positive in every fixed-income asset class since the Fed began this rate-raising cycle.
• Stay invested. It’s difficult, if not impossible, to time the interest rate cycle. Whether interest rates are rising or falling, staying invested and matching the duration of your bond investments to your investing time horizon and tolerance for risk still makes sense for most investors.