An unconventional perspective on interest rates

Despite predictions and announcements to the contrary, the Federal Reserve Board (Fed) might not raise interest rates at all this year.

That’s according to Richard Sheehan, Ph.D. and Senior Vice President, Analytics at MountainView Financial Solutions, a Situs company. He points to past years when the Fed consistently over-predicted the number of rate hikes it would carry out.

Indeed, at the end of the fall in 2018, the Fed projected three interest rate hikes in 2019, and it recently reduced that prediction to two. Sheehan mentions that in the past, the Fed’s optimistic perspective on future growth may have led its members to project more hikes than they undertook. This pattern of over-predictions is precisely why he believes that the Fed will have fewer rate hikes than it has planned for 2019.

“There may very well be no interest rate hikes this year,” says Sheehan.

At the end of 2018, the Fed bumped interest rates up after the president called for no interest rate increases. In bumping rates, perhaps the Fed was making the point that it is independent, although healthy Gross Domestic Product (GDP) growth and the low unemployment rate also likely warranted the increase. But the situation has changed since then.

According to Sheehan, the slowdown in the economy that began in the fourth quarter is likely not going to get any better in the first quarter. He cites the dip in consumer confidence; a slower housing market; the government shutdown; and, most importantly, the delayed impact of trade wars and barriers, which he expects we will see in Q1 and Q2 of 2019.

“Compounding this activity,” says Sheehan, “the tax cuts at the end of 2017 artificially boosted growth in 2018, but that growth was not sustainable, and likely contributed to Fed rate increases.”

While the aforementioned market factors seem daunting, Sheehan doesn’t think that these compounding factors will lead to a recession – at least not right away. Here is where Sheehan’s views take an unconventional turn.

While acknowledging the pain and financial loss that the government shutdown placed on families, contractors and small businesses, Sheehan also can’t help but put on his analytical hat.

“There is a chance that the shutdown potentially benefited us from a macro-economic perspective,” Sheehan says. “The shutdown will shave something off first-quarter growth, perhaps as much as 0.5% of GDP.”

Conventional wisdom might suggest that a reduction in GDP would make a recession more likely. But Sheehan likes to play “devil’s advocate.” He suggests that slower growth may lead the Fed to be much less aggressive than expected about rate hikes. If the unemployment rate stays in the 4.0% range, and if GDP grows at less than 2.0%, it is unlikely the Fed will raise rates.

“The Fed’s goal isn’t to generate a recession,” says Sheehan. “Their goal is to keep a reasonable growth rate without inflation — that is, without prices increasing by more than 2.0%.”

So far, we haven’t seen that type of price increase. Moreover, the Fed’s actions — in terms of raising rates — was possibly pre-emptive to ensure that  the higher growth in 2018 didn’t lead to crossing that 2.0% line. Thus, the expected slowdown likely precludes the need for much in the way of rate increases this year, which, in turn, makes it less likely that the Fed further increases rates and less likely that the economy moves into a recession.

If this point of view causes you some confusion, Sheehan has laid out the bottom line:

“We may just end up muddling along without great growth but also without a recession,” Sheehan says.

An interest rate plateau such as this could last for perhaps a year or longer. From a monetary policy perspective, this would be similar to the 2010-2013 period, albeit at a higher rate.

When asked whether he expects a recession, he answers like a true statistician. “The better question,” says Sheehan, “is what’s the probability that the economy would be in a recession by the end of 2020.” Sheehan’s reply back in Q4 2018 estimated that the probability was 20-30%, but his answer today is that the probability is slightly less – closer to 15- 25%.

He states, “The economic slowdown now could easily turn into a recession with just a little push, but based on where we are now and assuming some of the more sensitive external factors don’t intensify, we’re not likely to see a high GDP growth number, or a significant increase or drop in interest rates.”

As a final thought, Sheehan reminds us that the Fed has always been independent but very careful to take actions that would preserve its independence — and that means not doing anything that could be interpreted as politically motivated.  Now that the 2020 campaign is already underway, the Fed may likely be even more judicious in its decision to alter rates.