Why the U.S. Federal Reserve Won’t Be Hiking Its Policy Rate Any Time Soon

Dave Larock in Interest Rate UpdateMortgages and Finances

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The U.S. Federal Reserve met last week and decided to leave its policy rate unchanged, as was widely expected. The Fed also issued a brief accompanying statement, which gave us its latest assessment of how the U.S. economy is progressing. Here are the highlights from that statement:

  • The Fed sounded a little more upbeat about some of the recent data, noting that “near-term risks to the economic outlook have diminished”.
  • The Fed observed that “household spending has been growing strongly but business fixed investment has been soft”. I will expand on this key point below.
  • The Fed observed that “the labour market strengthened”, and that “economic activity had been expanding at a moderate rate”. It was encouraged that “job gains were strong in June”, but it also acknowledged “weak growth in May”. The Fed also noted that its dashboard of labour market indicators pointed toward some “increase in labor utilization in recent months”.
  • The Fed did not appear concerned about the effects of recent labour-market improvements on inflation, noting that “inflation has continued to run below the Committee's 2 percent longer-run objective” and that “market-based measures of inflation compensation remain low”. The Fed added that “longer-term inflation expectations are little changed, on balance, in recent months”.

While the Fed sounded more upbeat about the U.S. economy’s recent progress at the margin, it still lacks compelling evidence that its ultra-accommodative monetary policies have helped to foster sustainable economic improvements. Looking at the pattern of Fed comments over the last few years, we continue to see its key phrases oscillate between dovish and hawkish tones in a pattern that is as inconsistent as the underlying data they are based on. And that uncertainty doesn’t stop at the Fed – it is pervasive among business leaders and makes them reluctant to invest in the kind of capacity improvements and expansion that so many of the world’s economies desperately long for.  

Try as the Fed might with its aggressive policy initiatives, it can’t get companies to invest capital productively. Instead, business leaders focus on share buy backs, which boost price-earnings ratios instead of productivity levels, and on acquisitions, which win market share by buying the competition rather than by outperforming it. These non-productive forms of capital spending don’t produce lasting benefits for an economy, and in many cases, because those funds are then no longer available for more productive investment, they actually hurt it.

This lack of productive business investment is pervasive in many countries, including Canada, and policy makers just can’t seem to find a magic bullet to get companies to spend on the types of investments that would maximize knock-on benefits for their broader economies.

Against this current backdrop, it’s hard to see the Fed (or any major central bank) raising its policy rate any time soon, and the financial markets seem to agree because, at the moment, they aren’t pricing in odds for a Fed rate hike until July of 2017. More interestingly, prominent economist David Rosenberg recently observed that whenever the Fed has paused for more than six months after hiking its policy rate, as it has now done, its next rate move has always been a cut. Any bets on when the U.S. futures market starts giving odds of the next Fed policy-rate move being a rate drop instead of a rise?

Five-year Government of Canada bond yields fell four basis point last week, closing at 0.60% on Friday. Five-year fixed-rate mortgages are available in the 2.39% to 2.49% range, depending on the terms and conditions that are important to you, and five-year fixed-rate pre-approvals are offered at about 2.54%.

Five-year variable-rate mortgages are available in the prime minus 0.40% to prime minus 0.50% range, which translates into rates of 2.20% to 2.30% using today’s prime rate of 2.70%.

The Bottom Line: The Fed’s latest announcement was a little more upbeat at the margin but that didn’t shake the market’s belief that there won’t be any U.S. policy-rate changes until well into 2017. Furthermore, if history is any indication, the Fed’s next move will actually be a cut instead of a hike - and since U.S. rates are almost universally expected to rise before Canadian rates eventually do, that precedent helps to bolster the belief that our fixed and variable mortgage rates should remain at or near their current levels for the foreseeable future.

David Larock is an independent mortgage planner and industry insider specializing in helping clients purchase, refinance or renew their mortgages. David's posts appear weekly on this blog, Move Smartly, and on his own blog: integratedmortgageplanners.com/blog Email Dave

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