Interest rates can go up for one or all of the following reasons: Federal Reserve tightening, higher inflation, or increased demand for credit. Let’s examine these three variables. While the Federal Reserve will certainly reduce monetary stimulus someday, that moment is likely far down the road. Ben Bernanke, a self-styled “student of the Depression”, has said he fears a premature tightening, as occurred 1937-1938, just as the nation is finally on the mend.
U.S. economic growth is positive but it’s certainly not mended. For every positive economic report, it seems there is a negative one. For example, while home prices surged by 10.9% in the past year, it is widely attributed to slow building activity and tight supply of homes for sale. Lumber prices have recently been declining. Pending U.S. home sales increased just 0.3% in April versus expectations of +1.5%. A report of consumer confidence surged in May but actual spending fell by 0.2% from the prior month. Manufacturing activity in the Chicago region has climbed in recent months while the Richmond area has been just a little better than awful. It’s very much a mixed economic picture so there’s little reason for the Fed to change its easy monetary policy any time soon.
Further, there is virtually no inflation. A key gauge of inflation fell in April to its lowest level on record. Core inflation, excluding fuel and food, rose 1.1% in April from one year earlier, matching the smallest increase in prices since 1960. Overall prices, including fuel and food, rose even less, just 0.7%. Considerable slack in the economy, primarily high unemployment and weak consumer demand, has kept inflation in check. There’s little reason for interest rates to advance due to inflation.
Finally, interest rates rise when businesses and consumers demand increasing amounts of credit. However, the latest data from the FDIC suggests that bank lending has actually been shrinking in the U.S. In the past year, loan balances at the top 7,000 banks shrank by almost $37 billion, or 0.5%, fueled by lower credit card balances, home equity lines of credit and residential mortgage loans. Poor global growth prospects in Europe and China are keeping a lid on international lending. Loan demand will eventually help push interest rates higher, but it’s not a factor today.
Interest rates have jumped in the past month and trend-following investors have jumped on the idea that this will continue. However, there is scant evidence to support a near-term change in Federal Reserve policy, inflation or credit demand. The recent retreat in the prices of dividend-paying stocks should generally be considered a buying opportunity.
Richard G. Leader, CFA