Dreaming of Higher Interest Rates

Today's employment report, which shows a gain of 295,000 jobs and a lower unemployment level of 5.5%, knocked the wind out of the stock market's sails.  The Dow Jones Industrial Average fell almost 279 points or about 1.5%.  Bonds retreated as well, while the dollar rose.  The new employment data heightens the chances of the Federal Reserve Board raising interest rates as early as June, something that's detrimental to today's rosy asset valuations. 

In the past year, there have been innumerable rumblings from hawks and doves on the Fed about when to raise interest rates and how quickly.  As the economy has improved, the Fed's public signals have morphed from waiting a significant time and being patient, toward saying that their decision on rate increases will be data dependent.  That means rates could increase any time, if the Fed decides that the data warrants an increase.  Fed Chair Janet Yellen is a dove on rate increases, but she also wants to have a free hand without necessarily having to be patient.

There's so much debate and angst over rate increases that the sensible thing for the Fed would be to raise rates a quarter point this summer or fall.  That would give the markets a chance to adjust to a world without zero interest rates, something they haven't experienced in seven years.  After an initial tantrum, the market would probably figure out that 25 basis points is just 25 basis points, not the beginning of a massive depression and the end of civilization as we know it.  Some of the heat in the debate over rate increases would dissipate, and the dialogue could become calmer.  The hawks would have had their way, at least for a first step.  And the doves would realize they don't have much to worry about.

That's because economics would dictate that rates should remain low as long as inflation remains low.  Inflation, even without considering the falling price of petroleum, remains below 2%.  There is no economic justification for rates to rise much.  On or two quarter point rate increases would establish that the Fed is not locked into perpetual pedal-to-the-metal stimulus.  And low inflation rates would give the doves a basis for tightening ever so gently--and patiently.

So, if you're dreaming of higher interest rates, dream on.  When you wake up, you'll find that our low inflation reality means it was just a dream.