moneyOver the last few months we have heard a lot from the U.S. monetary authority, the Federal Reserve, about potential interest rate hikes in the near future.  The minutes of their monthly meetings  and statements made to the Senate Banking Committee have prominently mentioned this policy potential.  It has not yet acted on this warning, but markets and investors have been put on notice.

Why the  emphasis by the Central Bank on future rate hikes at this particular time?

A Central Bank can impact the markets and the economy in two ways.  First, by way of their  public statements, the mere hint of possible future monetary policy  influences the behaviour of investors today by altering their investment portfolios in advance of the change.  This is known as moral suasion.  Second, they actually implement policy changes (such as interest rate changes or money supply (QE) changes), thereby affecting investment markets and portfolios immediately.  The actual changes can either eminate from a previous warning or can be done as a surprise to the market.

There is a need for careful management by the Central Bank of the balance between the two types of policies.  I would argue that the use of moral suasion should be tempered, and when used it should be only after they have determined with absolute certainty that it is in the best interests of the economy to do so.  After all, if the Federal Reserve is such an accurate predictor of what is going to happen in the future, then they have found the key to the holy grail that all investors have been searching for.

Why the warning to investors and the markets that there may be a rate hike in the future?  There is no need for this right now.  Inflation (the control of which is one of the principle mandates of a central bank) is not even close to being an issue – falling oil prices are ensuring this.  The U.S. dollar has rallied sharply against all currencies, so there is no need to ‘defend the dollar’ by raising rates.  Employment is steadily improving, but the economy is not even close to full employment (a point where wages would start to rise materially), and a lot of the improvements in labour markets are occurring in sectors where employment contracts are loose and fluid (such as part-time work).

It appears the warning about future interest rate hikes is pure hyperbole that is not needed right now.  Warning of future interest rate hikes at this point is a case of the U.S. central bank taking an unnecessary and aggressive stance and has the potential of causing more harm than good in a fragile global economy.  Each policy warning leads to volatility in investment markets – not necessarily needed at this stage of the economic cycle.   Short term volatility leads to the inappropriate allocation of investment resources to non-productive uses – ie. speculation.

Of course, volatility is the best friend of value investors.  When managing investor expectations it presents the opportunity for value investors to take advantage of unnecessary price swings – induced by the Central Bank’s efforts to influence expectations – to make short term trading gains.  If you have done your homework and correctly determined the valuation of an investment based on its underlying fundamentals, and the Central Bank goes about knocking the price of that investment around, take advantage of the price-vs.-value gap in the short term to enhance your investment returns.