Fed At Risk Of Missing Window To Hike Rates

For much of the last year, the Federal Reserve has been repeatedly discussing the potential increase in the overnight lending rate. That rate, more commonly known as the "Fed Funds" rate, has been held at a historic low of .25% for an unprecedented 78 months, and counting, as the economy struggles to recover from the previous recession.

As a reminder, the Federal Reserve uses monetary policy to control inflationary pressures, or maintain price stability, and stimulate employment. This is what is known as the "Fed's Dual Mandate," which is an important concept to understand when discussing the Fed's current and future monetary policy stance.

During the "financial crisis" the Fed drastically lowered the Fed funds rate in an attempt to stimulate economic growth, employment and boost inflationary pressures. The near-zero interest rate policy was supposed to spur consumers and businesses into action by using low borrowing costs to jump-start economic growth. The problem for the Fed has been that while the economy did stabilize, exceptionally low-interest rates and massive "Quantitative Easing" programs, have been unable to put "Humpty Dumpty back together again."

In recent months, the Federal Reserve has become much more vocal about the probability of increasing interest rates sometime in 2015. Early speculation was that rate hikes would begin around mid-year, but the recent spate of economic weakness has pushed expectations out to later this year.

However, with the recent decline in many of the economic indicators, combined with the sharp fall in inflationary pressures, the question is why would the Federal Reserve risk tightening monetary policy at such a critical juncture? This is a question I pondered recently, stating:

"While the Federal Reserve clearly should not raise rates in the current environment, there is a possibility they will anyway - "data be damned." (Which is ironic for a "data dependent Fed.")

They understand that economic cycles do not last forever, and we are closer to the next recession than not. While raising rates would likely accelerate a potential recession and a significant market correction, from the Fed's perspective if just might be the 'lesser of two evils.' Being caught at the "zero bound" at the onset of a recession leaves few options for the Federal Reserve to stabilize an economic decline. The problem is that it already might be too late."

It is the last part that is most critical.

The Federal Reserve is hoping to lift interest rates from "zero" while the economy and inflation remain at sub-optimal levels. As I discussed in "The Mistake Everyone Is Making About Fed Rate Hikes:"

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"Therefore, rather than lifting rates when average real economic growth was at 3%, the Fed will not start this process at less that half that rate.

Fed-Rates-Vs-GDP-Table-050515Think about it this way. If it has historically taken 11 quarters to go fall from an economic growth rate of 3% into recession, then it will take just 1/3rd of that time at a rate of 1%, or 3-4 quarters. This is historically consistent with previous economic cycles, as shown in the table to the left, that suggests there is much less wiggle room between the first rate hike and the next recession than currently believed."