The Fed Stands Pat on Interest Rates

No increase in U.S. rates for now. It’s not good news.

The U.S. Federal Reserve Board has decided to hold off on raising interest rates for now.

For starters, it prolongs the uncertainty about when the Fed would make its move that has been overhanging the markets. A few weeks ago, it was widely expected to come at this month’s meeting. Now an increase is not likely to happen before mid-December and may even be postponed until 2016.

Worse, the delay reinforces growing concerns that the global economy, which has never really recovered from the Great Recession, is losing momentum. The day before the announcement, the Paris-based Organization for Economic Co-operation and Development (OECD) released a new forecast for world GDP growth in 2015 and 2016 and it wasn’t pretty.

The OECD shaved a tenth of a per cent off its global prediction for this year and two-tenths off next year. Canada fared especially badly. Our economy is now projected to grow only 1.1 per cent this year, down 0.4 per cent from the June forecast. For 2016, the OECD sees our growth rate at 2.1 per cent, a 0.2 per cent drop from previously.

The U.S. numbers held up pretty well, with 2015 growth projected to be 2.4 per cent, up 0.4 per cent from June (the Fed’s governors are somewhat less optimistic). Next year should be slightly better at 2.6 per cent, says the OECD.

It’s not U.S. growth that the Fed is really worried about. It’s what’s happening in the rest of the world. In its formal statement, the Open Market Committee said the U.S. economy continues to expand “at a moderate pace”. The labour market is improving “with solid job gains and declining unemployment”. It’s the rest of the world that’s troubling the policy makers.

The statement noted: “Recent global economic and financial developments may restrain economic activity somewhat and are likely to put further downward pressure on inflation in the near term”.

At a press conference following the meeting, chair Janet Yellen said the Committee decided to wait “in light of the heightened uncertainty abroad”. She added: “Given the significant economic and financial interconnections between the U.S. and the rest of the world, the situation abroad bears close watching.”

David Rosenberg, the highly respected chief economist with Gluskin Sheff + Associates, said in an article published on Globe Unlimited that the last time the Fed expressed such a high level of concern about the global economy was during the Asian crisis in autumn 1998. It was not until 10 months later that the Fed raised its target rate, he noted.

It appears that one of the factors that stayed the Fed’s hand was unease about the impact of a rate hike on the already too strong U.S. dollar. Driving the greenback higher at this stage is not good for anyone. It raises the cost of U.S. exports and reduces the profitability of multi-national companies, whose overseas sales are worth less in U.S. dollar terms. Developing countries are also hurt by a high dollar because the prices of the commodities they import, including oil, are fixed in U.S. currency.

The Fed also indicated that when the tightening does come, it will likely be more gradual than expected. “The Committee currently anticipates that, even after employment and inflation are near mandate-consistent levels, economic conditions may, for some time, warrant keeping the target federal funds rate below levels the Committee views as normal in the longer run,” the statement said.

In other words, expect interest rates to stay at unusually low levels for the foreseeable future.

So what does all this mean for your money? Several things.

Stock market malaise. Investors wouldn’t have been thrilled by a rate hike but at least it would not have been unexpected. It appears they were blindsided by the Fed’s worries about global economic weakness and the prospect of disinflation. Share prices in New York tumbled after the news came out and the sell-off continued on Friday morning. The price of oil sank and the U.S. dollar dropped while gold, the refuge in times of trouble, surged. Watch out for more volatility ahead.

Housing. Interest rates will remain low for some time to come in both the U.S. and Canada. That will provide on-going impetus to the recovering American housing market but will also continue to fuel the real estate bubble in Vancouver and Toronto, pushing prices even higher.

Fixed income securities. Yields on GICs and bonds will stay at near record lows. After the Fed announcement, the return on two-year U.S. Treasury bonds suffered the largest one-day loss in more than six years, finishing on Sept. 17 at 0.68 per cent. Yields on Government of Canada bonds fell across the board.

The bottom line is that the current uncertainty is likely to be with us for several months. That means more turmoil in financial markets and more churning stomachs for investors who are not comfortable with the asset mix in their portfolios.

If you count yourself in that group, take time to review your holdings and make decisions about what stays and what goes. Hold on to profitable companies with sound balance sheets and dominant industry positions. Consider selling speculative securities, even if at a loss. This is not a time to be out on a financial limb.