Federal Funds Rate Increase

Yesterday the Fed raised its federal funds rate 25 basis points from  0%  to 0.25%.  Its zero rate posture had been in effect for more than seven years.  Furthermore, the Fed suggested that normalization of this rate would proceed along a gradual glide path to exceed 3% over three years.

The Fed took this action before the economy had achieved one of its two objectives--an annual inflation rate of 2%. (The other objective, an unemployment rate down to 5%, had already been reached.)  The Fed's preferred measure of inflation, the core personal consumption expenditures price index, (or "core PCE"),  had only risen to 1.6%.  Apparently, they felt that recent rising wages would lead to a higher inflation rate,  so opted to act sooner.

Seven years of zero interest rates is unprecedented during the last 75 years, so whether the Fed's action is timely or not is difficult to determine.  I have written that a RAPID normalization of  long-term interest rates would result in a bear market due to the negative impact of rising interest rates on the stock market's price to earnings ratio.* (A rapid jump in the yield-to-maturity of the 10 year U.S, Treasury note, now at 2.25%, to more normal levels of 4% to 5%, would bring about such a downward stock market trend.)

If the gradual glide path were to happen, then a bear market might be avoided, because the normal  annual 6% to 7% earnings growth over three years would mitigate somewhat the price-to-earnings ratio compression.  If so, the total annual return of the S&P's 500 Index would be, at best, little more than the dividend yield, or slightly more than 2%.

Recessions have traditionally resulted from the bond market's response to virulent inflation.  In what seemed to be an off-hand comment yesterday,  Fed Chairwoman Yellen said there was no more than a 10% percent probability of the economy's entering into a recession in the near term.  I believe her low probability assessment  results from her feeling she can anticipate a recession and reverse her current path before it is too late.  However, the Fed's forecasting record is spotty at best.  And keep in mind that her ability to reduce interest rates significantly from here is unusually limited, and also that the economy's growth going into this rising interest rate environment has been subpar.  As I discussed in my last post**, today's environment is so unusual that a recession might result  just from the negative wealth effect of declining stock and bond markets.  I would assign a much higher probability than 10% to a recession within the next twelve months.

In addition to my 30% equity position,  I have maintained a 70% cash position in order to take advantage of the next bear markets in both stocks and bonds.   If I am wrong and the Fed's glide path case is correct, even then I should be able to add to my equity position at or near current prices sometime during the next three years.


*See my post, dated July 10, 2014, entitled "Shiller's CAPE Versus the 10 year U.S. Treasury Note Yield--an Important Negative Correlation."

**See my post, dated August 24, 2015, entitled "Will the Tail Wag the Dog?"