By Dennis & Christopher Fagan
Okay, so that’s a pretty poor play on words emanating from the recent pop song sung by Meghan Trainor (“All About That Bass”). However, it does aptly describe the position of the Open Market Committee of the Federal Reserve (FOMC), the policy-making arm that determines the direction of interest rates, after recently raising the target range for the federal funds rate to 0.25% to 0.50%.
For those not familiar with the financial markets, the FOMC raised the federal funds rate, the interest rate charged by member banks for overnight loans to other member banks on excess reserves held at the Federal Reserve. Of note, the last time the Fed raised this key lending rate was on June 29, 2006, when it moved 0.25% to 5.25%. However, after that as the Great Recession set in as a result of the financial/housing crisis, between September 18, 2007 and December 16, 2008, the FOMC cut this rate 10 times, culminating in a 0.75% reduction, which brought the fed funds rate to 0.00%.
The Fed noted that “given the economic outlook and recognizing the time it takes for policy actions to affect future economic conditions, the committee decided to raise the target range for the federal funds rate to ¼ to ½ percent. The stance of monetary policy remains accommodative after this increase, thereby supporting further improvements in labor market conditions and a return to 2 percent inflation.”
This much telegraphed move by the Fed was initially responded to in a bullish fashion by stock investors. Shortly thereafter, however, several external issues (the slowing economy in China, the unrest between Iran and Saudi Arabia, the supposed detonation of a hydrogen bomb by North Korea, immigration concerns in Europe, etc.), as well as the rhetoric surrounding the upcoming presidential election, have recently sent the market into a tailspin. We believe this is temporary as the economic fundamentals of the United States economy are sound and regardless of the noise to the contrary, will only improve in a low-cost energy environment.
We also believe the Fed will stay accommodative as, within its policy statement, twice the Fed used the word “gradual,” attempting to allay concerns that it would raise interest rates too aggressively. Therein lies the reference to the title of this column. Keep in mind that the Fed is very rarely explicit in its language, choosing rather to leave its policy statements open to interpretation. However, this time by using the word “gradual” twice, it wanted to convey to investors the seriousness of this matter.
The first time came within the second paragraph as “the Committee currently expects that, with gradual adjustments in the stance of monetary policy, economic activity will continue to expand at a moderate pace and labor market indicators will continue to strengthen.”
The second use of the word “gradual” appeared within the fourth paragraph as the FOMC noted that “the Committee expects that economic conditions will evolve in a manner that will warrant only gradual increases in the federal funds rate; the federal funds rate is likely to remain, for some time, below levels that are expected to prevail in the longer run.”
One final important change in the language of the policy statement pertains to the future reliance of the FOMC on “indicators of inflation pressures and inflation expectations” rather than just “inflation expectations,” as is usually the norm.
THE BOTTOM LINE: As noted above, investors may be wondering what this rate hike along with the next few that the Fed may have in store for us over the next twelve months may mean for their portfolios. We believe that the emphasis will continue to remain on the word “gradual” and that any increase in interest rates will be done only in the context of a moderately growing economy. In addition, the Fed will most likely want to see some stabilization in the energy markets prior to embarking on the path of tighter monetary policy. We believe that both will occur during the course of 2016 as most of the downside in oil has already occurred. For the stock market, we believe that the mid- to upper single-digit returns (including dividends) that we are projecting will closely mirror the growth in corporate earnings. For bond investors, we foresee a year much like 2015 with flat or slightly negative returns.
Best wishes for a happy, healthy and prosperous New Year!
Please note that all data is for general information purposes only and not meant as specific recommendations. The opinions of the authors are not a recommendation to buy or sell the stock, bond market or any security contained therein. Securities contain risks and fluctuations in principal will occur. Please research any investment thoroughly prior to committing money or consult with your financial advisor. Note that Fagan Associates, Inc. or related persons buy or sell for itself securities that it also recommends to clients. Consult with your financial advisor prior to making any changes to your portfolio. To contact Fagan Associates, call 279.1044.