The Fed's Warning Signal for Rate Hikes

If you're as interested in zzz-inducing articles as I am, you'll love this new press release by the Fed: ADVISORY ON INTEREST RATE RISK MANAGEMENT.  I hope you enjoy it as much as I did.

If, however, by the off chance that you're not interested in reading eleven pages on the management of interest rate risk (IRR, as the pros call it), I'll kindly sum up the report in a single sentence for you: "Hey banks, don't get too comfortable in this low interest rate environment."

All at a time when worries of inflation are soaring and when the economy is finally stabilizing in a sustained recovery. What does this all mean? The answer is clear: the possibility of higher interest rates.

In my opinion, the move was a smart one, albeit a coy one. Everyone knows that interest rates will rise sooner or later (it's impossible for the rate to sink lower, with the rate currently held at 0-1/4% for what the Fed forecasted would be an "extended period."). But the question of when has led to much doubt, and probably as a result, much speculation. But note that conspicuously missing from this press release is any mention about the time frame of a possible rate hike (in fact, there's no mention of raising interest rates at all, though the message is pretty clear).

This is not a mistake. Up until this point, the Fed has been in a catch-22 situation with half of the business world clamoring about inflation and the other half of the business world worrying about a double-dip recession. With this press release, the Fed is attempting to ease the minds of both groups, not an easy feat. For the inflation hawks, the press release sends a clear message to to them that interest rates will rise eventually, and reassures them that the Fed does indeed know what they are doing. For the double-dippers, the press release provides ambiguity, promising the eventual rise of interest rates (which we knew would happen sooner or later) but not specifying a time frame.

In other words, the press release is intended to be a much needed confidence boost, nothing more. I don't think that the Fed actually plans on altering its original course of keeping interest rates at 0-1/4% for an extended period, especially since the majority of the ARRA money is planned for FY10, which will significantly crowd out public consumption. Even if the Fed does indeed raise interest rates, I predict that the rate hikes will be very minimal (somewhere around 25 basis points) and only for the purposes of boosting confidence in the economy and keeping inflation expectations in check. I doubt that the Fed will take inflation seriously until either a) inflation gets out of hand, or b) until the economy is more or less functioning normally again.

For those of you who doubt me still, understand that I have been keeping up with the latest from the Fed. Even as the Fed establishes the Term Loan Facility for the eventual rise of interest rates, even as the Fed sets a time frame for the end of quantitative easing, even as the Fed is at a point where it could theoretically raise interest rates without having a significant effect on banks' lending practices (due to the large amount of excess reserves banks are holding), I am still not convinced that the Fed is willing to take serious (think Paul Volker) measures to curb inflation.

So in the end, all this press release does is buy time. At least that's my take.  But is that such a bad thing? I don't think so. The Fed doesn't disagree. The truth is that the current economy is unpredictable. A year from now, we will be in a much better position to evaluate the direction of our nation and the necessary policies to guide it. You know what they say: "Time is money."