Interest rates are again taking center stage as the global markets keep close watch on decisions being made by central banks around the world. By any measure, current global monetary policy is accommodative, making it relatively easy for economic expansion to occur. Lower interest rates mean lower borrowing costs for both businesses and consumers, driving capital expenditures and spending that may not have occurred otherwise. It also means lower rates on savings and fixed income, causing investors to migrate towards riskier assets in search of higher returns.
As a result, we have a market that has become accustomed to this accommodative policy. Also, this extended period of low interest rates has forced the investing public to compensate for a lack of yield, increasing risk in their investment portfolios by adding to their stock positions. Both of these elements add significant weight and potential market volatility to the outcome of interest-rate decisions, such as this week’s meeting of the FOMC.
Much of the current movement in the markets, especially as we get closer to Wednesday’s rate decision, is a result of speculation as to what policy will be like going forward its potential impact. Will rates be increased before the economy is strong enough to support them? Or will central banks wait too long, creating unwanted inflation?
History has shown that this concern is warranted, because the timing is both crucial and incredibly difficult to get right. This feeling of uncertainty and its effect on human emotion has the ability to move markets dramatically in one way or the other. It is also amplified in environments where people are taking on additional risk they may not be able to tolerate. This is precisely why Chairwoman Yellen is cautious when crafting her statements to the public.
The Federal Reserve is not looking to significantly disrupt the markets or derail the economy; in fact, this is precisely what they are attempting NOT to do. The two likely outcomes of this week’s meeting are either a rate increase of .25% or no change whatsoever to the fed funds rate. Neither of these decisions will have any immediate impact on the fundamentals of the economy at large, nor is a .25% rate increase large enough on its own to have any significant and measurable impact.
Changes in interest rates at the fed funds level take a significant amount of time to work their way into the system, and as a result, their impact is incredibly difficult to measure in real time. This is one of the reasons that rate adjustments are so difficult to time correctly.
As outlined in this quarter’s article “How Will the Election Affect the Markets?”, markets can be extremely volatile in times of increased uncertainty. They also tend to react strongly on speculation of what is to come, rather than to actual changes in the underlying health of the economy itself. Regardless of the outcome of this week’s meeting, the volatility and any resulting adjustments will be short-lived as the market regains its composure and refocuses its attention on the signal rather than the noise.