Who's Afraid of the Big Bad Fed?

by Max G. Ansbacher

Probably the first investing principle which is taught to anyone who enters Wall Street is, “Don’t Fight the Fed.” This means that if the Fed is raising interest rates, which they normally do to cool off the economy, then you don’t want to be bullish on the market. Contrarily, if the Fed is lowering interest rates, usually to prod the economy to do better, then it’s OK to buy stocks. 

Today with interest rates at almost zero it’s obvious that the next change in rates will be upwards. As a consequence of this, huge numbers of market participants, especially in the bond sector, remembering this rule are trembling with trepidation at the thought that this will be bad news for the bond and stock markets.

Recently I attended a lecture by the esteemed Vice Chairman of the Federal Reserve, Stanley Fischer, at the Economic Club of New York. He pointed out some interesting facts as to why this adage about “Fighting the Fed” may not be applicable this time if and when the Fed does raise rates. 

To understand this, one has to recognize why the Fed has traditionally raised rates in the past--it has been to help it carry out its dual mandates of restraining inflation and encouraging full employment.  When the economy was sizzling and inflation was taking off, the Fed raised interest rates to cool the boom and to keep our currency strong. Then when the economy slowed, it lowered rates to make it easier to borrow money and invest in the economy.

Now the interest rate situation is completely different. Rates cannot be lowered because the Fed has already determined that we will not have negative rates here in the U.S. Furthermore, the usual reasons for raising rates are not present, i.e. there is virtually no inflation, the dollar is very strong, and the economy still has plenty of slack in it. 

Nevertheless, Vice Chairman Fischer said that the Fed may raise interest rates in the near future in an effort to “normalize” the economy. This is a far less urgent purpose for raising rates than fighting runaway inflation or saving a collapsing currency. Therefore, the Fed can act deliberately and at the speed it wants.

Mr. Fischer said that when and if it does raise rates, it will be slowly and gradually. He stated, “We will be raising rates from an extremely low level to a very, very, very low level.” I believe he intimated that the initial increase would be to a quarter of a percent or half a percent. And because of what we’ve discussed above, it could be a long time before they raise them further.

So who’s afraid of the big bad Fed? If they do raise rates it will be because they believe that the economy is once again strong enough to support interest payments. This is a good reason to be bullish on the stock market. And the tiny initial increase that Mr. Fischer described is certainly not going to have any significant impact on the economy. This time, it might actually make sense to “Fight the Fed.”

Of course an announcement from the Fed that they are raising rates would depress the stock market initially just out of habit by those who are following the old rule. But for the reasons cited here, believe it or not, it could be just the thing to actually launch another market rally.