Pulling The Band-Aid Off Slowly

Federal Reserve monetary policy once again came to the forefront as the Fed released its April minutes last week. After living through years of a ZIRP (Zero Interest Rate Policy) coupled with QE (Quantitative Easing), many market participants and commentators are begging for a swifter move back to “normalization” (a Federal Funds Rate target set closer to historical averages). The economic wounds from the financial crisis may be healing, as seen in the improving employment data, but rather than ripping off the interest rate Band-Aid quickly and putting the pain behind investors, the dovish Fed Chair Janet Yellen has been signaling for months the Fed will increase rates at a “gradual” pace.

Despite the more hawkish tone regarding the possibility of an additional rate hike in June, Fed interest rate futures are currently still only factoring in about a 26% probability of a rate increase in June. As I have been saying for years (see “Fed Fatigue”), there has, and will likely continue to be, an overly, hyper-sensitive focus on monetary policy and language disseminated by members of the Feral Reserve Open Market Committee.

For example, in 1994, despite the Fed increasing target rates by +2.5% in a single year (from 3.0% to 5.5%), stock prices finished roughly flat for the year, and the market resumed its decade-long bull market run the subsequent year. Today, the higher bound of Fed Funds sits at a mere 0.5%, and the Fed has announced only one target increase this cycle (equaling a fraction of the ’94 pace). Even if investors are panicking over another potential quarter point in June or July, can you say, “overkill?”

While the Fed is approaching the lower-end of the range for its employment mandate (unemployment currently sitting at 5%), despite the recent bounce in oil prices, core inflation remains in check (see Calafia Pundit chart below). This long-term benign pricing trend gives the Fed a longer leash as it relates to the pace of future rate hikes.