After 17 consecutive interest rate hikes during the past two years, the Federal Reserve’s open market committee decided on August 8 to leave the federal funds rate unchanged at 5.25%. While stocks immediately rallied in response, they fell back as it became clear that inflationary pressures persist, and they could prompt more rate hikes in the future. What does this mean for markets and investors? Wharton finance professor Jeremy Siegel told Knowledge at Wharton that Fed chairman Ben Bernanke met expectations, and “meeting expectations is very positive for stocks.”
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Jeremy Siegel on the Fed’s Decision to Pause Interest Rate Hikes
Knowledge at Wharton: After 17 consecutive interest rate hikes, the Federal Reserve decided on August 8 not to raise the federal funds rate. Joining us to discuss this recent decision is Jeremy Siegel, professor of finance at the Wharton School. Professor Siegel, thank you so much for joining us here.
After two years, the Federal Reserve Committee has decided, in a 9-to-1 vote, to leave the Federal funds rate unchanged at 5.25%. In your estimation, was that a prudent decision?
Siegel: Yes. That was the right decision. After last Friday’s employment report showed considerable softness, the market moved to the expectation that the Fed would pause. It’s very important in central banking that you meet the expectation of the market. If [Fed chairman Ben] Bernanke had thought that the market was incorrect in coming to the conclusion that there would be no rate increase today, he would have had to guide it to that decision by some announcement or speech on Monday or over the weekend. When he didn’t do that, it meant he agreed with the assessment of the market. And so, as a result, it was not a surprise. I think it was the right thing to do — the economy is slowing down. Inflation is still there, but the slowdown should have the effect of moderating a lot of that inflation.
Knowledge at Wharton: Let us talk about the short-term versus the long-term effects. I understand sometimes it takes almost a year for interest rate hikes or even the decision itself to take full effect on the economy. Are there short-term implications?
Siegel: When I learned macroeconomics, we talked about long and variable lags. Milton Friedman used to talk about that in terms of the effects of monetary policy. We always thought about a year or a year-and-a-half impact on prices, sometimes even longer than that. And when you look at the statement that the Fed released, it twice mentioned the cumulative effect of the increase. …We moved to 5.25%, but it’s going to take many months for that to bite into the economy. It’s already beginning to bite into the economy. So in other words, Bernanke and the Fed are very cognizant of the cumulative effects, they don’t want to overdo it. They want to let the monetary policy work its way through, see if it controls inflation, and then if it does not, they will have to move later this year.
Knowledge at Wharton: The market’s reaction immediately was that stocks started to rally.
Siegel: Immediately, but then — it’s interesting — they fell, actually ending down on the day. I think the reason for that was that most people expected the pause. So, it was sort of built into the price earlier today (Tuesday). And they said, what else is there? They did see that the warnings of inflation and the risks of inflation are still there, which kept the door open — which of course Bernanke had to do — that they may raise rates in the future. So when they looked at the whole thing, bond and stock markets rallied immediately. And then when they looked at it they said that [in the] long-term, it’s not going to change things that much, and they actually fell back.
The same thing happened on the dollar and foreign exchange markets. So there isn’t really that much change [in] meeting expectations. I think meeting expectations is very positive for stocks. You don’t want a central banker or central bank that goes against expectations.
The only thing that really surprised me about the press release was that it was very short in terms of the statement. It was much shorter than it has been the previous two times. It was just very bare-bones, using many of the very same phrases that Bernanke used last June — basically saying [that] the basic forces are there, it’s just that the slowdown has now come, it’s not just anticipated, it is here, we can afford to pause at least one meeting to assess the situation.
Knowledge at Wharton: The Fed release noted that “some inflation risk remains” in the economy. Does this mean the Fed could resume raising interest rates after this pause?
Siegel: Most certainly. They would have to leave that door open. If they close that door and say we can afford not to raise [rates] for a long time, the markets would get very worried that we have a central banker that’s not concerned about inflation. We see oil in the $77-78 [range] — commodities are still very, very high. The year-over-year increases in inflation don’t look good. We talked a little bit about that in the last podcast — that it might in fact happen. So, clearly, he had to still be very alert.
Do notice, by the way, that there was a dissent. Jeffrey Lacker from the Richmond Fed (president of the Federal Reserve Bank of Richmond) wanted an increase of 25 basis points. There were dissents in the early and middle years of [Alan] Greenspan’s 17-year tenure at the Federal Reserve. It’s not all that unusual. That’s one thing the markets saw — dissents aren’t all that common [either]. They saw one dissent in favor of a rise in rates, they knew there was controversy at the meeting, and that if inflation does not cool off, the group that wanted higher rates could of course become more powerful and eventually force the hand of the FOMC (Federal Open Market Committee). Now, of course, it’s way down the road. But a dissent in favor of raising rates probably raised an orange, if not a red, flag of caution among some of the players in the market.
Knowledge at Wharton: Had the vote had been 5-to-4, would that have been more dissent?
Siegel: That would really upset the market because it means that the chairman could not get an overwhelming approval. One or two dissents are okay; no more than two. If it’s more than two, it’s a very severe split, and it rarely happens. So, that would have disturbed the market in the sense that Bernanke could not get more of a majority in his favor. One dissent is really not a problem.
Knowledge at Wharton: Let’s talk about the housing market, which is obviously one of the big sufferers recently — with new home sales, existing home sales, all going down. What’s your take on what this will do?
Siegel: Well, that’s the big question mark on the slowdown. It is coming down pretty rapidly. What is actually interesting is the fact that long-term interest rates are down — to 4.90% on the 10-year [Treasury bond] — which means that the fixed-rate mortgages are actually beginning to ease a little bit, maybe by a quarter or three-eighths of a point from where they were just four weeks ago. That might help prevent a hard landing on real estate.
Commercial real estate, by the way, is still doing very good. What I’m hearing among realtors is, “Yeah, buyers are disappearing, prices are soft.” But a few of them told me they haven’t seen such a strong rental market. People are essentially saying, “Hey, you know what? I’m going to wait and rent in the meantime.” Actually there is a shortage of renters. Rentals are now going up relatively rapidly as [home] prices went down. [That is] the opposite effect of what we have had over the last three or four years — as prices go up and rentals remain relatively soft. So, with rental income very, very strong, commercial real estate very strong, that’s going to moderate the impact of housing making a hard landing on the economy.
Knowledge at Wharton: Is the strong rental market just in the metropolitan areas or is it across the market?
Siegel: That’s what I’ve been hearing from the top realtors in the Philadelphia area. I won’t be surprised if that’s also occurring in other major metropolitan markets.
Knowledge at Wharton: Let’s look at the international situation. The most recent edition of The Economist has an interesting analysis on central banking in the emerging economies and how interest rates everywhere have been going up. Do you expect international bankers to respond to the Fed’s decision, or is it too premature to say?
Siegel: There is always a feeling that there is more coordination among the central bankers than in fact there is. You often get [speculation] when the ECB (European Central Bank) or the Bank of England start raising rates rapidly that the [U.S.] Fed is going to raise rates too. Really, they act very independently. What we see in the emerging markets is the fact that they are still extremely strong. India, China and again, commodities are very, very strong in price. So, as a result, to contain those inflationary pressures, I’m not surprised to see that increase. We saw the ECB raise rates, the Bank of England raise rates — that was last week.
One should remember that those rates are still under the Federal Reserve rate. The Federal Reserve rate is the highest among the major central banks in the world. That’s rather unusual, but it does exist now. So the Fed could afford to pause while other central banks are raising rates.
Knowledge at Wharton: Professor Siegel, let’s shift gears to Alaska and what’s going on there with BP in Prudhoe Bay. What would be its economic impact?
Siegel: Well, that obviously knocked the market yesterday. I thought we had a pretty good rise if it weren’t for that. The market is so tight that a little bit of a disruption is something that sends those prices higher. Let’s just hope that other pipelines are not suffering the same corrosion problem. That could be a major, major factor.
When we look at external events impacting oil prices, we should also say that on the favorable side, we have a reduction in the predictions of severe hurricanes in the Gulf and the Florida region. As we know from Katrina, they were playing havoc with the energy markets. So, we’re having some problems with the pipelines here in Alaska, we’re having some good news perhaps on the hurricane front. There’s always going to be these events happening in a market that is so tight and nervous; it’s going to react to any of this information.
Knowledge at Wharton: So with interest rates holding steady now, what’s your advice to investors?
Siegel: Well, my feeling is that the Middle East crisis and the premium it is putting on oil is probably holding the stock market back 5% to 10% at least. Earnings came in beautifully in the second quarter, the price/earnings ratios are getting compressed. With interest rates under 5%, it’s a real strong buy towards stocks.
Again, the risk is a real flare-up in the Middle East and oil going to $80, $90 or $100, as some people think. People are saying they don’t want to commit a lot of funds there. If anything would improve in the Middle East, you would get a big upward bump in the equity market.
Knowledge at Wharton: Professor Siegel, thanks so much for joining us today.
Siegel: Thanks for having me.