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The Fed Faces The Donald

Marriner S. Eccles Federal Reserve Board Building, Washington, D.C.
The Marriner S. Eccles Federal Reserve Board Building , Washington, D.C. Photo by William Warby.

Will the election of Donald J. Trump to be the next U.S. president frighten the Federal Reserve away from raising interest rates this year – or will it provide more reason to do exactly that?

There is a case to be made for either argument, but the financial markets may have already made the decision on behalf of Fed Chairwoman Janet Yellen and her colleagues. By the time Trump sat down with President Obama at the White House on Thursday to discuss the transition, rates on 10-year Treasury bonds were hovering around 2.10 percent, up 50 basis points (100 basis points equals 1 percentage point) since the end of September, with more than half of that rise coming just since the election.

The Fed does not directly control longer-term rates; its activities affect the short end of the market. But the 10-year rate is a closely watched benchmark because it has wide and deep effects on the economy. If you apply for a mortgage, chances are good that the bank will set the rate it quotes you at a certain level above the 10-year Treasury rate.

So if Yellen and company proceed as they had been expected to do, with a quarter-point boost in short-term rates at their December meeting, they would really just be catching up to the bond market’s post-election move, assuming rates remain near late last week’s levels.

On Tuesday evening, as election returns increasingly pointed to an unexpected Trump victory, global financial markets convulsed; a lot of observers were talking of a market shock akin to what occurred after last June’s Brexit vote. But in less than 24 hours, the U.S. equity markets had recovered, with the Dow Jones Industrial average closing at a record high on Thursday. Those knee-jerk reactions to the electoral surprise will have no impact on the Fed’s deliberations weeks from now. Market trends between now and decision time might be a different story, but only if something happens during this early part of the transition to make the Fed governors believe the risks to the economy have significantly heightened. Considering that Trump will still be more than a month away from taking the oath of office, this seems unlikely.

A more likely outcome is that the Fed remains on course despite the election – or maybe, in light of the bond market’s movements, that course is even more firmly carved than before. Data leading up to Election Day certainly led many investors, myself included, to consider a rate hike in December nearly certain. At the moment, I see nothing that would make me change my view.

The October jobs report, which the Bureau of Labor Statistics released on Nov. 4, was the sort of news that would have encouraged the Fed to proceed with a rate hike. The number of new jobs, at 161,000, arrived slightly below the estimates of some economists. Yet wage gains, year over year, rose around 2.8 percent. While this increase is hardly gangbusters, it is the best 12-month percentage gain since the early stages of the recovery from the financial crisis. And the labor force participation rate, holding at 62.8 percent, has at least stabilized for now after a long downward slide. Unemployment, at 4.9 percent, is also holding at a healthy level.

Just before the labor report arrived, Fed officials had indicated the central bank was merely waiting for “some further evidence” of a tightening labor market and the potential of an inflation spike before it acted. The jobs report seemed to provide such evidence.

Any increase will not be very large – as mentioned above, a quarter of a percentage point is most likely. And the increase will come a full 12 months after the last rate hike finally put rates above zero. At the time, the Fed projected three or four increases over the course of this year, gradually raising rates by a full percentage point prior to the start of 2017. But with other nations pushing rates into negative territory, which was already driving up the dollar, and amid the uncertainties of the Brexit vote and the American presidential election, the Fed found reason after reason to delay action.

With the election over and economic growth holding steady, the Fed must weigh any risks of moving too soon against the potential cost of delay. In an October interview with The New York Times, Eric Rosengren, the president of the Federal Reserve Bank of Boston, expressed concern about waiting too long to raise interest rates. “You can’t wait too long to start if you want to make sure it’s going to be gradual,” Rosengren said. “If we wait too long to start raising rates, I don’t think we will have the luxury of moving as gradually as I would like.”

One reason given over the past months by the Fed official who preferred to wait was that, while the labor market has improved this year, inflation has still run below the Fed’s 2 percent target. But as The Wall Street Journal reported, that may be beginning to change. “Core” inflation, which excludes food and energy prices, rose 1.7 percent year-over-year in the third quarter of 2016. The expectation of inflation, too, can end up affecting the spending decisions of businesses and households, which in turn affect actual prices over time.

A December rate hike will be modestly good news for savers and significantly better news for banks. On paper, the U.S. economy seems well-positioned to withstand a small hike, and an increase has to come sometime – gradually now or, potentially, sharply later.

But don’t be surprised if financial markets, including stocks, bonds and currencies, react sharply and negatively to the Fed’s decision.

This may seem counterintuitive if the economy is strong and the Fed is only going to raise rates incrementally. But the explanation is simple enough: Despite years of near-zero interest rates, the United States is still far out in front of the rest of the world in trying to normalize financial conditions. European pessimism seems unlikely to abate any time soon, especially with the United Kingdom poised to leave the European Union in the next few years. Japan continues to try to kick-start its sluggish economy, and opacity in China means conditions there are hard to evaluate from the outside. The Fed is left more or less alone in the vanguard as the U.S. inches back toward normalcy.

Any soldier can tell you that the person who is “on point,” leading his platoon into the battlefield, is the one most likely to encounter land mines or sniper fire. Being out in front is liable to make anyone a little jumpy.

So get ready for a rate hike next month. And don’t overreact, even if the markets do.

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