[AUDIO INTRODUCTION] Welcome to the Bryn Mawr Trust Wealth Management Podcast, providing commentary on what’s moving the financial markets, financial planning, and other timely business and monetary topics. Please welcome your host, Jennifer Fox, president of BMT Wealth Management.
[SPEAKER: JENNIFER FOX] I’m speaking today with Jim Barnes, director of fixed income at BMT Wealth Management. Jim, welcome.
[SPEAKER: JIM BARNES] Thanks, Jen.
[SPEAKER: JENNIFER FOX] Jim, after last week’s meeting of the Federal Open Market Committee, or FOMC, Federal Reserve chairman Jay Powell was upbeat when discussing US economic growth. His somewhat hawkish tone opened the door to potentially more than expected rate hikes in the short to medium term. What implications would aggressive monetary policy have on economic growth in the United States?
[SPEAKER: JIM BARNES] I think that Chairman Powell is correct with his overall upbeat economic assessment of the US economy. Based on the economic data that we have received thus far in the second quarter of 2018, economic growth is running at an annualized rate of probably close to 4%, which is a number that we have not seen since 2014.
The healthy labor market is providing consumers with more spending power, while the manufacturing and non-manufacturing sectors in the US both remain very comfortably in expansionary territory. Given the current historically low interest rate environment, I believe that further rate hikes by the Federal Reserve are justified with, simply, the primary objective being to remove some of this accommodative monetary policy that’s been in place in this system for many, many years now.
The simple reality is that, given the current state of the US economy, there probably isn’t any need to keep rates as low as they currently are.
[SPEAKER: JENNIFER FOX] Are there any risks to raising rates too aggressively?
[SPEAKER: JIM BARNES] There are. I think it’s very important that we make a very clear distinction between raising rates gradually versus raising them aggressively. Moving rates up too fast can definitely lead to some unintended consequences for the US economy. Higher than expected interest rates could very well lead to less consumer and business spending, both of which would be negative for economic growth down the road.
I don’t, however, believe that this is the Federal Reserve’s intention, although I would expect them to conduct monetary policy very carefully with each additional rate hike that’s administered going forward.
[SPEAKER: JENNIFER FOX] Jim, do you think the financial market is in good position to absorb a more aggressive stance from the Federal Reserve?
[SPEAKER: JIM BARNES] I think that, over the years, investors have become very comfortable with simply slow and steady. The equity markets have performed very well since the last recession, going back to 2008 and 2009, considering that the economy has been averaging a growth rate of roughly 2% over this time period.
It is important to note that, although this growth rate is positive, it is somewhat subdued relative to prior economic expansions. I think that a sharp, unexpected rise in interest rates could very well act as a headwind for the equity markets. There could be some concerns over corporate profits that would be factored into investor trading behavior, and could very well lead to downward pressure on company valuations.
The ultimate fear is that by raising rates too quickly, the Federal Reserve could very well choke off the ongoing economic expansion. It’s also worth noting that right now, we have seen some countries outside the US that appear to have been struggling in an environment with higher interest rates coinciding with a higher US dollar, especially those countries that import more relative to what they export, as well as those countries that may have issued a lot of debt in the US dollar.
Continued rate hiking on an aggressive basis by the Fed could prove to be somewhat problematic for those countries. Again, it’s not our base case scenario, but it’s something that we are looking at closely and needs to be considered.
[SPEAKER: JENNIFER FOX] So what about the yield curve? Does more Federal Reserve tightening lead to higher long-term rates?
[SPEAKER: JIM BARNES] Not necessarily. The short part of the yield curve is going to be more influenced by monetary policy decisions. When the FOMC raises that target range and indicates, at the same time, that current economic conditions warrant additional rate hikes down the road, short term bond yields will generally adjust higher. We actually saw this play out at the end of last week’s FOMC meeting, when the two-year treasury note increased three basis points in yield and closed out at roughly 2.6%.
The longer part of the yield curve, however, tends to be more reactive to changes in actual inflation, as well as inflation expectations. A more hawkish tone followed by more aggressive monetary policy by the Federal Reserve could end up being a drag on long term bond yields and lead to an even flatter yield curve.
The simple rationale is that higher short-term rates could very well lead to a slowdown of economic growth, leading to lower inflation. After last week’s meeting at the FOMC, the 10-year US treasury yield ended the day roughly unchanged, which leads me believe that investors were pricing in a less hawkish stance from the Fed.
Ultimately, I think that longer term yields have a much better chance of rising when the Federal Reserve is gradually raising rates, as opposed to aggressively raising them. The rationale here is that lower interest rates, a lower interest rate environment, allows the economy more room to expand, and more ability to generate inflation.
[SPEAKER: JENNIFER FOX] So we’re just about the halfway point through the year, and there are four FOMC meetings remaining on the calendar for 2018. Do you think the Fed will take an aggressive approach when conducting monetary policy?
[SPEAKER: JIM BARNES] I don’t think so. I think that the Federal Reserve will continue to maintain a very gradual approach to raising rates and removing accommodative monetary policy. It’s very important to note that, while inflation has been increasing, it’s still very much within the Federal Reserve’s comfort zone of 2%.
I think that so long as inflation doesn’t venture too far away from this 2% mark on a sustainable basis, there is no reason for the Fed to be overly aggressive when raising rates.
[SPEAKER: JENNIFER FOX] Jim, thanks very much for your insights and your time today.
[SPEAKER: JIM BARNES] Very happy to do it.
[AUDIO CONCLUSION/CLOSE] This has been a production of Bryn Mawr Trust, copyright 2018, all rights reserved. Visit us online at bmtc.com/wealth.
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