The Fed is in a tough spot. When is it safe to raise interest rates? The Federal Reserve - the nation's central bank - has the dual responsibility of keeping prices stable (low inflation, no deflation) and keeping Americans employed. Right now, that challenge is a big one.
The economy isn't really booming, and the Fed doesn't want higher rates to slow our meager economic growth, most recently demonstrated by the downward revision in fourth quarter 2014 GDP. But then the latest strong jobs report gave the Fed cover to possibly raise rates sooner than expected.
There are pluses and minuses for the economy if the Fed pushes rates higher. Here's a look at the possible impact:
• Savers/Borrowers. There's good news for savers if the Fed acts soon. They will earn more interest. But there's bad news for the government. It will have to pay higher interest rates to borrow money to fund its deficits each year - and to roll over old debt as it comes due. With a $220 billion bill for interest this year, even a small rise in rates could add to the deficit.
• The Stock Market. There's both good news and bad news for the stock market. In 1999 and 2004, when the Fed started raising rates, stocks sold off immediately - but then showed gains six months after the Fed began hiking rates. Market historian Jim Stack (www.Investech.com) says that "historically the start of a Federal Reserve tightening cycle seldom triggers major losses in the stock market." Still, whenever investors start anticipating that the Fed is about to raise rates, the stock market sells off in an emotional, if not historically correct reaction.
There is one plus for the stock market if the Fed raises rates. It will make the U.S. dollar more attractive to foreign investors. And that could send more money into the stock market, as well as into fixed income, dollar-denominated bonds.
• Bonds. There's a simple rule bond investors need to know: When interest rates rise, bond prices fall. That's because no one wants to get stuck holding long-term, low-rate bonds if the general level of rates is rising. They could then buy equally safe bonds paying a higher interest coupon. So when higher rates are on the horizon, many investors sell their bonds - pushing prices down. That rule applies to all bonds - government, municipal, corporate, and even fixed packages of bonds in funds. The longer the "maturity" of the bond, the greater the price decline when rates rise.
Of course, the market has been waiting for the Fed to raise rates for almost two years now. And it hasn't happened yet. Trading the bond market based on interest rates requires different, but equally challenging, skills as calling tops and bottoms in the stock market.
• The Dollar. Higher interest rates make the dollar more attractive to own, sending its value higher in comparison to alternatives such as the Euro, British Sterling, or the Japanese Yen. If a foreigner switches into dollar-denominated Treasury notes, they will earn a lot more interest than if they invest in their own currency.
You might think it's nice that the dollar has more value. You certainly can buy more goods and services if you visit Europe or Japan. But the downside of a strong dollar is the fact that when American companies sell products overseas, they earn less after converting their profits back into dollars. And, the strong dollar means American goods are more expensive overseas, cutting into sales of American multi-national companies. Lower profits and lower sales are bad for stock prices!
You see that the global economy - even with the Fed at its center -- is really a very circular process. What the Fed does here in the United States ripples throughout our economy - and throughout the world. The Fed's responsibility is only to our own economy -what's best for the U.S. But they can't help but be aware of the impact of their actions throughout the world.
When will the Fed raise rates? When a group of 12 individuals - the Fed's Open Market Committee -- balance out all those issues, read all the research about business conditions around the country, debate the impact on both markets and jobs - and then make an "educated guess" about what's the "right" thing to do.
They may be better informed, but they have no more certainty about the timing or impact of a rate hike than you or I do. And that's The Savage Truth.