Is Fed Tightening a Policy Mistake?

March 16, 2015

Is Fed Tightening a Policy Mistake? Photo

This week’s big event is the Federal Reserve (Fed) meeting on Wednesday. Market participants have been split on whether the Fed will drop the “patient” language, and if it does, what that will mean for the market. I have been asked several times during the past few weeks if the Fed will raise interest rates, and if so, when? Despite the economic data being relatively strong recently, I believe the Fed should tread cautiously in raising interest rates.

Employment has been trending positively for some time now, and the unemployment rate has fallen solidly below the Fed’s target of 6.0%. Other growth indicators have been mixed such as the Gross Domestic Product (GDP) and last week’s University of Michigan’s Consumer Sentiment Index, which fell from 95.4 to 91.2. I am definitely seeing more strength in some of the lagging indicators of the economy, while leading indicators are starting to trend lower.

However, growth is only one half of the Fed’s dual mandate, and inflation continues to be below the Fed’s target of 2%. I think inflation will remain below the 2% level for the foreseeable future. These domestic factors are exacerbated by a consistently strengthening dollar and weakness in key global economies. In this environment, I believe the Fed should remain very cautious and deliberate in any tightening, or it may potentially suffer the fate of the European Central Bank (ECB), which has had to reverse course on prior tightening and now is engaged in significant quantitative easing and negative interest rates.

The Fed wants some policy flexibility and is inclined to raise interest rates later in 2015, but this may not be the correct policy action. I continue to expect increased market volatility in the near term. In the short term, I am modestly bearish on stocks and credit spreads and bullish on interest rates, especially the long end of the yield curve.

Tags: Monday Morning O'Malley | Federal Reserve | Interest Rate | Market volatility | European Central Bank | GDP | Consumer sentiment

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