Amid signs of steady economic growth but low inflation, Federal Reserve policymakers will meet this week to consider another change in short-term interest rates. Will they or won’t they hike rates?
The Fed typically adjusts the federal funds target rate—the rate banks charge each other for overnight loans—to balance or head off rising inflation. In March, it boosted the range by a quarter percentage point to 0.75% to 1.0%. Yet by most measures inflation has been turning lower recently.
“The Fed’s preferred inflation measure—the index of prices for personal consumption expenditures (PCE) excluding food and energy—has been below the 2% target since 2012, and has recently fallen back to 1.5% versus a year ago,” says Kathy Jones, chief fixed income strategist at the Schwab Center for Financial Research. “Markets aren’t indicating concerns about inflation either. The Treasury Inflation Protected Securities (TIPS) breakeven rate, the 5yr/5yr forward rate and the flattening of the yield curve all signal that inflation expectations are falling.”
Given that, some investors may wonder why the Fed may raise rates at the June 13-14 meeting. Kathy says two reasons make sense:
Reason 1: The Fed’s forecasting models say inflation is near—even if markets don’t believe it.
“The Fed’s models say that inflation should pick up soon due to a tightening labor market,” Kathy says. “With unemployment at 4.3%, Fed officials have been clear that they believe the U.S. has reached or even exceeded the threshold for full employment—a level of unemployment where just about anyone who is looking can find a job. When the job market is that tight, employers usually end up boosting wages to find workers. Although wage growth remains subdued, Fed officials believe that it’s just a matter of time before wages rise, fueling stronger consumer spending and inflation.”
Financial conditions are also supportive for a Fed rate hike, she says. With the stock market near all-time highs, interest rates low, the dollar down more than 3% in the past six months, and credit spreads very narrow, the door is wide open to companies and individuals to access markets for credit.
“The current reading on financial conditions is close to the most accommodative in three years, and about where it was during the boom years of the 1990s and early 2000s,” Kathy says.
Reason 2: The Fed needs to normalize policy so it will have tools to fight the next downturn.
With interest rates still very low, the Fed doesn’t have much room to deal with the next financial crisis and/or recession, Kathy notes.
“If the Fed can raise interest rates and lower the balance sheet, there will be monetary policy tools available again,” she says. “If we go into a downturn with rates low and the balance sheet high, the Fed may not be able to do much more to counter the deflationary pressures. That might leave the U.S. in a similar position as Japan, where years of expansive monetary policy have produced very little in the way of results.”
What to expect from the Federal Open Market Committee meeting:
Kathy says it’s likely that the Fed will raise short-term rates by 25 basis points, or 0.25%, at this week’s meeting. Some detail also may be provided on how the Fed plans to reduce the amount of Treasury securities it’s holding on its balance sheet.
“Fed officials have already signaled the desire for a gradual approach that would put the reduction on ‘auto pilot’ so as not to have a big impact on markets,” Kathy says.
Also interesting, Kathy says, will be the Fed’s quarterly Summary of Economic Projections. “I’ll be looking to see if the Fed has revised its longer-run estimate for the fed funds rate again,” she says. “It was lowered from 4% to 3%, but it is still well above where the market believes the funds rate will go over the next few years. I don’t know if it will be changed this time, but we still believe 2% to 2.5% is probably the highest the funds rate will go in the next few years, given the demographic trends and ongoing low inflation.”
What investors should consider
Kathy suggests keeping average fixed income portfolio duration in the short-to-intermediate term. Limiting average duration to the three- to five-year (as far out as seven to 10 years for municipal bonds) area provides exposure to most of the yield curve, while potentially limiting volatility, she says.
Focus on high-quality bonds for the majority of your fixed income portfolio—investment-grade corporate and municipal bonds, along with Treasuries and certificates of deposit (CDs), should be less volatile than lower-credit-quality bonds like high-yield or emerging market bonds, Kathy says.
Also, consider investment-grade floating rate notes, she says. Floaters have very short durations and the income paid is linked to short-term rates. Floaters may benefit from rate hikes by the Fed. Bank loans are also another option—but remember that these are high-yield and less liquid than most bonds, she says.
Finally, remember to match duration to your investment horizon. “If you expect to need the money in the next one to two years, it should be in CDs or very short-term Treasuries—not a bond fund that tracks the Bloomberg Barclays U.S. Aggregate Bond Index, with a duration of six years,” Kathy says. “If you need the money in the near term, consider a mix of maturities. Bond ladders can provide a way to avoid too much duration concentration.”
What you can do next
- Make sure your portfolio is diversified and aligned with your risk tolerance and investment timeframe. Want to talk about your portfolio? Call a Schwab Fixed Income Specialist at 877-566-7982.
- Watch Schwab experts discuss other market and economic topics in the Schwab Market Snapshot.