Be Careful What You Wish For

The “dog days” of summer typically are slow times in the securities markets, as many participants embark on vacations and extended weekends. However, two events occurring in the first eight days of August are being awaited with both eagerness and trepidation. The first is the monthly unemployment report, which is usually released on the first Friday of the month, in this case August 4th . The second is a meeting on Tuesday, August 8th of the Federal Reserve’s Open Market Committee (FOMC), after which the FOMC will announce if they will raise the Federal Fund’s rate for the eighteenth consecutive time since June 2004. The Fed will also release a brief statement after the FOMC meeting, which investors watch closely in order to try and gage the probability of future interest rate moves. After the previous (June 29th) meeting, the Fed hinted that they may not need to hike rates further if the economy shows signs of slowing. Since higher interest rates in general raise the cost of doing business, many investors believe that the stock market will benefit if the Fed decides to pause on Tuesday. They reason that stock prices will advance without facing a headwind of higher interest rates. But does this logic make sense? Indeed, it is a textbook case of “be careful what you wish for”. First, let’s take a look at the basic dynamics behind the FOMC’s mechanics. The Fed has a 2-pronged mandate to foster economic growth while containing inflation. One of the main tools at the Fed’s disposal is to raise or lower the interest rate it charges member banks, the Fed Funds rate. The trick for the Fed is find the right level that will allow the economy to expand, while keeping inflation under control. The Fed lowers (or “eases”) the Fed Funds rate to stimulate economic growth when needed, and raises (or “tightens”) the Fed Funds rate to slow down growth in order to keep inflation in check. This is not an easy balancing act, since it can take anywhere from 6-18 months for the Fed’s moves to impact the economy. The Fed will almost always err on the side of tightness, since it is extremely difficult to contain inflation once it gets out of control (anyone remember the 1970’s, Paul Volcker and WIN buttons?). Back to the current economy and stock prices. The unemployment report on Friday did indeed fall below expectations. The economy only added 113,000 jobs in July (an increase of 144,00 was expected), and the unemployment rate rose for the first time since February, to 4.8% from 4.6%. This news came barely a week after the preliminary estimate of GDP growth for the second quarter came in at 2.5%, lower than market estimates of 3.2%. These numbers do indeed suggest the economy is slowing, and many pundits are citing this lower growth as the impetus for the Fed to leave rates unchanged at Tuesday’s meeting. The initial reaction was positive for stocks, with the major indices rising immediately after the report was released. However, if the Fed does decide to leave the Fed Funds rate unchanged, it will do so because they are concerned about the rate of economic growth over the next several quarters. A slowing economy does not bode well for stock prices, and the major stock indices gave up their gains later in the day on Friday, with the Dow Jones Industrial Average and the S & P 500 Index posting very small gains for the week. Even with the weak unemployment report, it is not a given that the Fed will leave rates unchanged. Inflation is still running slightly higher than the Fed’s comfort zone, with the broad-based Consumer Price Index (CPI) growing at an annual pace of 4.7%, compared to 3.4% last year. Also, a pause by the Fed on Tuesday does not rule out another increase in subsequent meetings later this year. So before stock investors get too exited about lower interest rates, they should keep in mind the reason why the Fed will stop, and be careful what they wish for.