The last time the Federal Reserve raised interest rates, the iPhone and Twitter had yet to debut. That the Fed has raised them now, even by a mere quarter of a percentage point, signifies that after the better part of a decade, we are entering a new era.
What does the increase mean for the economy? For agriculture? To assess that, it helps to ponder the Fed's reasons for making the move and the risks it's taking in making it.
Reasons for raising rates:
-- With the unemployment rate now down to only 5%, the economy seems to be approaching the Fed's target of a "maximum level of employment." If the labor market is really as strong as the jobless rate suggests, workers will soon be demanding and getting higher wages. If they do, inflation could easily surpass the Fed's 2% target. By raising rates, then, the Fed is expressing confidence in the economy's future. That should tend to give financial markets a boost.
-- Transparency is essential in central banking these days, and the Fed has for some time been transparent about its intention to raise rates. Lately it has been so transparent about a December 16 rate increase that failing to move would have undermined its credibility. Financial markets do not like to be misled; central banks cannot afford to have their credibility undermined.
P[L1] D[0x0] M[300x250] OOP[F] ADUNIT T
More Recommended for You
Recommended for You
-- Rates can't remain near zero forever. If the Fed had kept them there, it would have faced a number of dilemmas, including what to do when the economy next lapsed into recession. Zero rates would leave few tools in its toolbox. Negative interest rates? Possible, but Europe's experience with them is discouraging. More "quantitative easing?" Possible, but the returns would likely be diminishing given how much liquidity the Fed has already pumped into the markets.
-- There are risks to raising rates just now -- we'll get to them in a minute -- but long periods of near-zero rates present their own risks. To be sure, encouraging risk-taking has, in some sense, been the Fed's objective. Interest rates near zero pressure investors to seek out riskier investments. Investment was what the Fed was trying to stimulate. The recent mini-crisis in the junk-bond market is a reminder that some "reaching for yield" investments pose a threat to the financial system's stability.
Risks in raising rates:
-- Atop the list of risks for agriculture is a skyrocketing dollar. Ag exports are already suffering from the dollar's strength. The U.S. dollar index, which measures the dollar's value against a basket of currencies, had soared 15% to 100.51 in early December, up from a 52-week low of 87.63. Not everyone thinks the dollar will continue its rapid ascent, to be sure. It's possible markets have already priced in a Fed rate increase. But as CoBank president Mary McBride told the DTN/The Progressive Farmer Ag Summit, the dollar will likely continue strong even if it doesn't rise much more until some major economy other than the U.S. starts to show signs of recovery. It could be a long wait.
-- A quarter-point increase in ag-mortgage and operating loan rates won't sabotage many business plans, but where is the Fed headed from here? If this is the first of many rate increases over a short period of time, ag's big borrowers will eventually feel the pain. Thankfully, this is not the most likely scenario. More plausibly, the Fed will tread cautiously. In its statement announcing the increase, the Fed stressed the word "gradual" in talking about future increases. And Fed officials have been forecasting a Federal Funds rate a year from now around a percentage point higher than today, between 1.25% and 1.5%. Their forecast for 2018 has been 3.5%. If they're right, rates would continue well-below their historical norms. Still, it's clear the new direction for interest rates is up.
-- Ignore markets' unruffled first reaction to the move. By taking the first step toward higher rates, the Federal Reserve starts down a very different path from the central Banks of Europe, Japan and China, which are still trying to stimulate growth. This divergence has the potential to rile stock, bond, currency and commodity markets. It creates opportunities for trades exploiting differences in interest-rate and currency expectations and tempts investors to bail out of existing trades. In addition, countries with currencies pegged to the dollar will find it hard to keep stimulating as the Fed tightens. China has already indicated it will unpeg the Yuan from the dollar and re-peg it to a basket of currencies (http://tiny.cc/…).
-- While the U.S. economy has been growing, the growth has hardly been vigorous. Some analysts worry that the Fed will tip the economy back into recession. That, in turn, would require the central bank to make a U-turn and start cutting again.
Conclusions: The most important thing that just happened is the change in the direction of rates and the indication that there will be more steps down this new path. The next most important thing is the modest size of the increase and the assurance that future increases will come gradually. And the thing to watch is inflation. The faster prices rise, the more likely the Fed will be to tighten further.
Will this all end well? The Fed's rate setters apparently think so. They voted unanimously for this increase despite the risks and in the face of skepticism in the markets and among economists. They know a mistake could have severe consequences. They're convinced they've found a Goldilocks solution -- not too weak, not too strong, just right. Whether the economy and the markets can lie comfortably in this new bed, time will tell.
Urban Lehner can be reached at email@example.com
© Copyright 2015 DTN/The Progressive Farmer. All rights reserved.