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 nick.timiraos@wsj.com and Rachel
Louise Ensign at rachel.ensign@wsj.com
(END) Dow Jones Newswires
December 18, 2018 07:14 ET (12:14 GMT)
Copyright (c) 2018 Dow Jones & Company, Inc.