By Nick Timiraos in Washington and Rachel Louise Ensign in New York
In a world of low inflation and slow recuperation from the financial crisis, even small interest-rate changes can have outsize effects on markets and the economy.
That is a key lesson that Federal Reserve officials have learned as they prepare another short-term rate increase at their policy meeting this week. With markets unsettled and the economy slowing, the officials are wondering whether they should slow the already-anemic pace of action.
The Fed has moved its benchmark short-term rate up to a little over 2% since 2015, remarkably little action when considered against history. In the early 1980s, for example, it moved in even larger increments in a matter of weeks to boost already double-digit rates. Even in the 2000s, when the Fed moved rates up at a "measured pace," the sum of its actions over three years amounted to more than 4 percentage points of increases.
Rate actions in the 2000s did little to end a bull market, but markets now are flashing warning signs, even with rates still at low levels. The Dow Jones Industrial Average has fallen more than 10% since the Fed's last move in September, and the Chicago Board of Options Exchange's VIX index, which measures market volatility, has moved above its average during the expansion that began in 2009.
The economy also shows signs of slowing from robust growth earlier in 2018, in part because interest-sensitive sectors including housing and car purchases have lost momentum. Growth abroad has softened.
Charles Himmelberg, chief markets economist at Goldman Sachs, compares the recent dynamic to a frog that doesn't realize it is being boiled. Fed policy moves "didn't feel like much at the time, but in hindsight, they're maybe feeling more burdensome," he said.
It is one reason officials are considering slowing down the already slow pace of rate increases in 2019.
At the end of its next meeting Wednesday, Fed officials are set to raise their short-term rate for the ninth time since they began raising it from near zero in December 2015, bringing it to a range between 2.25% and 2.5%. By contrast, from June 2004 to 2006, the Fed raised rates 17 times, from 1% to 5.25%.
Fed officials expect the so-called neutral interest rate that neither spurs nor slows growth is lower than it used to be, which is one reason smaller changes in the federal-funds rate could have outsize effects.
Another unknown for the Fed comes as its moves are being amplified by another factor. As it pushes up short-term interest rates, the central bank is also gradually shrinking a $4 trillion portfolio of mortgage and Treasury bonds. It is trying to be deliberate with these steps, too, but the effects are largely unknown, adding to angst at the Fed.
"There's no textbook on unwinding a balance sheet like this," said Federal Reserve Bank of Dallas President Robert Kaplan in a Dec. 7 interview. He said the process requires extra "vigilance" in managing policy.
While that process has been running for more than a year, the Fed has increased the amounts of securities that will roll off the portfolio this year to $150 billion a quarter, up from $30 billion when the process began. And the European Central Bank this month will end its own bond-buying campaign, meaning the largest central banks' balance sheets will decline next year for the first time this decade.
Scott Minerd, chief investment officer at Guggenheim Partners, said the Fed's moves encouraged companies to pile on debt when rates were low. With rates now rising, the Fed's actions have begun shifting investors away from riskier corporate debt.
Spreads between 10-year Treasurys and medium-grade corporate debt have hit their widest point in two years, though spreads remain considerably tighter than during periods of market stress seen in 2015 and early 2016.
In the corporate-debt market, recent volatility has led issuers to step back from new deals for now. "People want to hit the pause button," said Stephen Foley, head of corporate banking at TD Bank.
The housing market has been among the first sectors of the U.S. economy to slow. Low levels of new construction this decade and low borrowing costs fueled sharp price gains, particularly in coastal cities.
"All of the market was priced as if a 4% mortgage would last forever," said Glenn Kelman, chief executive at national real-estate brokerage Redfin. "Consumers had forgotten what a more normal mortgage rate is."
In California, more than three of every seven homes for sale in October had their asking price reduced at least once, the highest such share in seven years, according to the California Association of Realtors.
The unwind had only minimal effects when the Fed initiated it last year because officials assured markets they could slow rate rises if the wind-down proved disruptive.
Investors didn't profess much concern about tighter money earlier this year, when tax cuts, federal spending and synchronized global growth provided a lift to corporate profits and the broader economy.
"It's not so much that investors had priced it in as they set it aside," said Mohamed El-Erian, chief economic adviser at Allianz SE, the German insurance giant.
That changed this fall, he said, when the Fed began to pull back on the amount of verbal guidance it gives to markets about its near-term rate plans. Concerns mounted about slower global growth and rising trade tensions between Washington and Beijing.
Stock markets in October posted their worst month since 2011. After rising to a seven-year high in November, the yield on the 10-year Treasury has steadily fallen around 0.4 percentage point as investors' expectations of higher inflation and tighter monetary policy have receded.
Many economists see the Fed's rate increases doing more to cool down growth than the shrinking bond portfolio. The Fed's holdings have fallen to $4.1 trillion from $4.5 trillion a year ago and are set to reach $3.6 trillion in a year. Economists at Goldman Sachs estimate the runoff is equivalent to another 0.1 percentage point increase in the federal-funds rate next year.
Former Fed officials don't see the runoff as a main source of market stress. "The reaction has been much milder than one would have anticipated," said William Dudley, who until June was president of the Federal Reserve Bank of New York.
Mr. Dudley said other factors better explain recent market volatility, including a more challenging environment for corporate earnings that no longer get a boost from tax cuts, a tighter labor market weighing on profits, and either weaker economic growth or tighter monetary policy.
"All of that is on top of the risks of a trade war," he said.
Banks initially enjoyed a boost from the Fed's rate increases. The central bank's moves allowed lenders such as Bank of America Corp. and JPMorgan Chase & Co. to charge higher rates on loans but not pay out much more in interest to depositors. The rate stance and last year's corporate tax cut led to record profits.
Now, the outlook is more complicated. Mortgage refinancing has plunged, cutting profits in the home-loan business. And many banks are under pressure to pay depositors more while the unwinding of the Fed's balance sheet is decreasing the amount of deposits in the financial system.
"As the Fed reduces balance sheets...that's $1 trillion out of deposits, " JPMorgan CEO James Dimon said in October. "That will change the competition a little bit for deposits."
During the years when the Fed kept rates near zero, deposits and loans at New York-based Signature Bank grew at double-digit rates, making it an investor darling. But in the past year, the bank's net interest margin, a metric of lending profitability, has shrunk because its deposit costs are rising faster than the yields on its commercial-real-estate-heavy loan book.
"It's a steel cage match" for deposits, said CEO Joe DePaolo at a conference this month. "It's been as tough as it's ever been." The $46-billion-asset bank's business clientele is now routinely getting offers from other banks for better rates, he said.
Write to Nick Timiraos at firstname.lastname@example.org and Rachel Louise Ensign at email@example.com
(END) Dow Jones Newswires
December 18, 2018 07:14 ET (12:14 GMT)
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