The Federal Reserve (Fed) surprised virtually no one by raising its target on short-term interest rates on Wednesday. What the central bank said in doing so, however, is worth every investor paying attention to.
First, the basics: The Fed bumped up rates by a quarter percentage point, bringing the range on the fed funds rate to 0.50% to 0.75%. It was the Fed’s first tweak to interest rates in just about a year and only its second in nearly a decade. But in doing so, the Fed also suggested it may be somewhat more aggressive in lifting rates down the road.
Today, we think it’s vital to understand that most developed-market central banks are coming to believe something we have felt for years: At this stage, very low interest rates (especially negative rates) and flat yield curves for long periods of time do little to support growth in the real economy. Indeed, as we move into 2017, investors (and the Fed) may likely be dealing with an altogether different outlook for the economy and economic policy than they have been in recent years. The hallmarks of this new policy will be reflation, inflation, and greater optimism that a more productive balance between growing fiscal and receding monetary policy stimulus can be found.
In fact, when viewed in the light of rate normalization, and potentially significant fiscal stimulus from a U.S. government now unified under the Republican Party, it’s fair to ask if we have reached the end of a period that has been characterized by excessive central bank accommodation, financial repression, low growth, low inflation and low yields.
Feeling More Optimistic
In other words, is the economic pessimism that has come to be thought of as our “normal” condition overdone? We think it is, and believe risk markets, such as equities, are likely to be well supported, rates can move moderately higher, inflationary expectations can continue to accelerate, and most importantly, economic and financial investment can and will grow alongside of this. We see central banks heading down more appropriate policy paths, and believe markets will continue to respond accordingly. In addition to stocks, in such an environment investors may also want to consider Treasury Inflation-Protected Securities, or TIPS, which offer protection against inflation.
Of course, there may be setbacks along the way, and other bouts of political risks could well jolt markets in the year ahead. It’s also true that neither monetary nor fiscal policy can substantially alter the demographic profile and rapid technological change that is enveloping the country. But we do believe along with higher levels of volatility, markets will be encouraged by a more sensible policy mix that stands a better shot of improving growth prospects for a broader population.