July 23, 2013
Late in the second quarter, Federal Reserve Chairman Ben Bernanke announced the Fed might, later this year, begin tapering off the asset purchase program it has used to stimulate the U.S. economy. Interest rates rose sharply, and financial markets were rattled. In a recent interview, Alan Levenson, chief economist for T. Rowe Price, discusses the U.S. economic outlook in the context of changing Fed policy.
Levenson says he was not surprised by the Fed's announcement nor by the market's reaction to it. The Fed has signaled this move since December. As for investor reactions, Levenson attributes it mostly to a willingness to ignore earlier signals and remembers a similar reaction in 1994. He points out that the reason that the Fed is moving forward with its target time line is because the economy is continuing to improve and strengthen. If that changes, the Fed can change its plans.
Bernanke himself was a bit surprised that interest rates rose as much as they did following the announcement. Levenson contends that the announcement may have been a catalyst, but in actuality, rising interest rates were long overdue given the fundamentals of the economy. In April, real rates on 10-year Treasuries were negative, which was unprecedented, and not in keeping with a slowly improving economy. In reality, Levenson says, the interest rate rise was more of a normalization.
There has been some concern that higher interest rates could slow economic growth. Levenson has been predicting that the economy will grow 3% in 2014, and he's not inclined to adjust his forecast significantly lower at this time, anticipating that rising interest rates will have a negligible effect. He also doubts that higher rates will threaten the housing recovery because rates are rising on an improving economy. Employment is improving, consumer confidence is increasing, and housing is still affordable. Banks also should be more willing to lend with a higher differential between short- and long-term rates. This combination of positive forces should outweigh any drag from higher interest rates, particularly as mortgage rates are still quite low by historical standards.
While fiscal policy dominated headlines and investor concerns at the beginning of the year, it's largely moved to the back of investors' minds. The U.S. moved past the fiscal cliff crisis, and the impact of budget cuts and tax increases has been largely absorbed by consumers. People have seen that the private economy is still moving forward, and they are less worried about economies abroad as European countries took measures to address their debt crises. But Levenson cautions against too much optimism. The long-term problem of entitlement spending reform has not been resolved, and the debt ceiling issue will likely raise its ugly head again this fall.
The Fed's quantitative easing program has not pushed inflation higher, despite the concerns of some pundits, and Levenson says we're not at risk of deflation either. He says the unemployment rate is still higher than levels that would spark inflation and that it will likely be a couple of years before we see real inflationary pressures.
Levenson observes that the big picture is that the economy is moving in the right direction, and downside risks are significantly lower than this time last year. He predicts that the Fed will indeed begin tapering asset purchases around September, winding them down completely by mid-2014. As far as raising the federal funds rate, the Fed has tied its potential actions to progress in the labor market, saying it would not raise rates until unemployment reaches 6.5%. Levenson believes we'll get there earlier than 2015, as the Fed has predicted. Since the unemployment number is a threshold and not a trigger, however, the Fed could still hold off on raising rates, particularly if inflation is low.