Must-know: Risks associated with a premature liftoff in rates

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Nov. 26 2019, Updated 12:07 p.m. ET

Timing lags in achieving the Fed’s dual mandate

When the Fed’s inflation and employment targets aren’t reached in a certain amount of time, it impacts the normalization rate. If the Fed overestimates the labor market recovery, a slower normalization pace is needed. In contrast, if the Fed overshoots its inflation goal, due to an accommodative monetary policy, the liftoff needs to be accelerated.

William Dudley and Charles Evans discuss the economic implications of a rates increase

The liftoff also impacts economic growth. When the rate increases higher and quicker, it could jeopardize the economic recovery. This scenario could involve going back to the Zero Lower Bound (or ZLB) or keeping the federal funds rate near zero levels.

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“There are some reasons to try to be patient…you want to make sure that when you do lift off, you’re actually successful,” said Dr. William Dudley, head of the New York Fed. He spoke at the Bloomberg Markets Most Influential Summit in New York on September 22. He warned that a premature liftoff could cause economy to weaken. This would force policymakers “to reverse course.”

He also stated that the ZLB wasn’t a really “comfortable” place to be in. Monetary policy tools at the ZLB were limited. Also, the ZLB had economic consequences for savers. Although the financial crisis was about debtors, the monetary policy response had been hard on savers. They weren’t getting a positive return. He wanted the Fed to get off the ZLB as soon as possible because it would benefit savers. Getting off the ZLB would also restore flexibility in using the federal funds rate as a policy tool.

Charles Evans on the federal funds rate

“The decision to lift the funds rate from zero should be made only when we have a great deal of confidence that growth has enough momentum to reach full employment and that inflation will return sustainably to 2%. We should also proceed cautiously and keep the path of rate increases relatively shallow for some time after we begin to raise rates,” said Dr. Charles Evans. He spoke at a labor market conference in Washington, D.C. on September 24.

Both Dr. Dudley and Dr. Evans talked about Japan during the 1990s and the 2000s. They also mentioned the U.S. during the Great Depression. In both cases, when monetary accommodation was removed prematurely, the economies slipped into recession. The central banks were forced to backtrack and bring back accommodative monetary conditions.

Investor impact

If the recovery stalls, the economy could slip into a recession. This scenario would be bearish for stocks (DIA) (SPY). A recession would also bring back loose monetary policy. It would lower the federal funds rate again, after the liftoff. This would lower Treasury (TLT) (UST) yields. During economic uncertainty, investors prefer safer assets like U.S. Treasuries and investment-grade bonds. Volatility (VXX) usually increases during economic uncertainty.

Click here to learn how the federal funds rate impacts investments.

In the next part of the series, we’ll discuss the factors that could bring in earlier rates increases.

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