Blog : Higher Interest Rates? Not So Fast

by Ed Zwirn on March 20th, 2014

If you think you're going to get a better yield on that bank CD or other low-risk investment any time soon, think again.

In what may very well have been the first time public utterances by Janet Yellen actually made the stock market go down, Wednesday afternoon's inaugural press conference by the chair of the U.S. Federal Reserve was followed by a pronounced market downturn. The occasion for this mini-debacle was a remark by Yellen that a rise in short-term interest rates could occur six months after the end of the quantitative easing taper.

QE, through which the Fed pumps money into the system by purchasing Treasury and mortgage-backed securities, is in the process of being scaled back. As per Wednesday's Fed announcement, purchases of this paper will go down to $55 billion monthly as of April, the latest in a series of "taperings" trimming the program, which as of late last year had been purchasing $85 billion monthly. As Yellen pointed out, assuming the trimming continues at the same rate, these purchases would end this fall, although the Fed will still hold on to the considerable portfolio it has acquired through QE.

Recalling that Yellen had said that a rise in short-term interest rates could come six months after that, this would presumably mean that the current near-zero federal funds rate would continue only until April 2015, a date considerably earlier than the analyst consensus that a rise in rates (meaning a contraction of the money supply as regulated by the Fed) would not be in the cards until the end of next year.

But are rates going to rise as soon as all that? I doubt it.

For one thing, as Yellen made clear, the Fed, in dropping the 6.5% unemployment rate threshold as a tripwire for a possible rate hike, was bowing to the reality that, despite moderate labor market gains, the economy is far from overheating and obviously has a long way to go before unemployment reaches below 5.8%, the highest of the rates specified in a range of "ideal" unemployment rate targets in its most recent long-term policy statement in January.

For another, unemployment is only one component of the Fed's mandate, which calls for maximum employment and minimum inflation. As the Fed reaffirmed in this same January document, the lowest inflationary level consistent with a growing economy is found to be 2%, a rate of price growth well in excess of the current reality. Fed stated policy is to maintain low rates for at least until inflation rises beyond that point.

But a poll of the Fed governors themselves, which Yellen presented as one of her press conference exhibits, shows that none of them expect inflation to go above 1.6% this year, and 2% starting in 2015. Even the most extreme predictions among them do not call for inflation above 2% in the foreseeable future, going out past 2016.

This was underscored by the tenor of the press conference. Yellen kept uttering the word "inflation," probably more frequently than any recent Fed chief, in response to hypothetical questions from the press about whether and when the Fed would begin to raise interest rates. In other words, near-zero rate targets are appropriate for as long as the Fed can use them as a tool to boost the economy while facing no inflationary threat as a result.

And the evidence from the inflation front would seem to indicate that not only is this threat a long way off, but also that inflationary expectations, such as they are, are continuing to exceed inflationary (or deflationary) realities.

As reported in my most recent Penny Stock Week, the producer price index for February had been expected to show little movement. But instead of the 0.2% rise forecast by most analysts, the PPI fell by 0.1%. More importantly, the "core" figure, which excludes the more volatile food and energy components and so is considered a better measure of underlying "monetary" inflation, fell even more in February, by a greater-than-expected 0.2%.

Following in step, the consumer price index, a less leading indicator than the PPI, also came in at a lower-than-expected inflationary level. Tuesday's CPI showed prices rising by only 0.1% (the consensus had called for a 0.2% increase) in February, the same as the prior month. The core also rose 0.1%, the same rate of increase seen in January.

The upshot for penny stock investors: Barring any unexpected uptick for inflation, low rates are likely to stay with us for much longer than six months after the end of the QE tapering. Any move to raise rates before a healthy rate of inflation kicks back in would only exacerbate the current deflationary pressure by making money more valuable.

For the stock market, this means speculative investments should continue to benefit from the Fed's easy money policies, at least until inflation ticks up, because investors looking for yield will in effect have nowhere else to go. This is not the same as saying the market will go up, but it can't hurt.