The REAL Reason Yellen Is Raising the Federal Funds Rate

Alexander Green
by Alexander Green, Chief Investment Strategist, The Oxford Club
federal funds rate 0

Last week, Federal Reserve Chairwoman Janet Yellen announced that the central bank would continue raising short-term rates.

No surprise there. The Fed has lifted rates four times already - and made clear its intention to continue tightening.

What is surprising, however, is that Fed officials resolutely refuse to state the real reason they’re doing this.

So let’s take a closer look...

The central bank purportedly exists to maintain stable prices and create full employment.

Full employment is a squishy term. Historically, it has meant an unemployment rate of less than 5%.

We’ve been there for over a year now.

However, the current unemployment rate of 4.1% fails to take into account all the employable men and women who have given up looking for a job.

Yet with economic growth hitting 3%-plus for two straight quarters - and hiring up - even these folks are being pulled off the sidelines.

As for stable prices, that hasn’t been a problem lately either.

Yes, the cost of healthcare and college tuition is rising faster than most prices. But the core inflation rate is just 1.8%.

Yellen claims she can’t understand why it’s not higher with economic growth and job creation strong.

But what’s more bewildering is why the Fed wants higher inflation. After all, that benefits no one.

Even a 2% inflation rate cuts consumer purchasing power in half over 36 years.

So let’s consider the real reason the Fed wants to raise rates. Is it to tamp down the stock and bond markets?

Absolutely not.

Falling asset prices undermine consumer confidence and cause households to slam shut their wallets, undermining economic growth.

Is it to benefit savers? Hardly.

Over the last nine years, ZIRP - the Fed’s Zero Interest Rate Policy - has hurt no one more than savers.

Consumers who have set aside safe money to reach short-term goals - like raising a down payment for a house or paying next term’s tuition - have earned essentially nothing.

So why is the Federal Reserve really raising rates?

For one simple reason: to put the arrows back in its quiver.

If we started sliding back into a recession, the traditional monetary response would be to slash interest rates. But when the benchmark is at 1%, there isn’t much to cut.

Moreover, investors are hardly in the mood for Quantitative Easing IV, V or VI. (Especially since the Fed is trying to unload its multitrillion-dollar bond portfolio, not build it up.)

There isn’t much to hope for on the fiscal side either. Having run massive deficits under former Presidents Bush and Obama, the national debt now stands at $20.57 trillion.

We've already had the fiscal stimulus (for what it was worth). Piling on more debt in the next recession would only put us in the same league as Greece and Venezuela.

The central bank’s real desire is to slowly raise interest rates - without rattling consumers, investors or business owners - to a level where it can once again stimulate the economy (at least theoretically) by bringing them down again.

So - instead of letting everyone scratch their heads - why doesn’t the Fed simply say so?

Perhaps it’s because when investors realize how little both Congress and the central bank could do to bail us out of the next recession, it would undermine consumer confidence and spook financial markets.

Let’s hope the Fed doesn’t need to cut rates soon, especially since it can’t do much anyway.

But let’s also recognize that a lack of effective policy options is one of the greatest risks facing investors today - and we should govern our portfolios accordingly.

Good investing,

Alex

Thoughts on this article? Leave a comment below.

Believe It or Not, This Dividend Payer Is Looking Forward to Rising Rates

The conventional wisdom says that rising interest rates are bad for dividend payers - especially real estate investment trusts (REITs), which are required by law to pay out at least 90% of their net income in dividends.

Yet Alex and his Oxford Communiqué subscribers have been profiting from a notable exception to this idea - Equity Residential Properties Trust (NYSE: EQR).

Here’s Alex checking on the REIT last month...

REITs are highly liquid. They allow you to own a diversified portfolio of income-producing properties in a single investment.

They have a low correlation with the stock market, making REITs a great portfolio diversifier. And because they are required to pay out at least 90% of their net income to shareholders each year, they are also reliable dividend payers.

Some analysts believe the higher yields make them vulnerable to an interest rate rise. But there is no evidence to support that.

During five of the six periods since 1978 in which the Fed lifted short-term rates, REITs generated positive returns and outperformed both U.S. stocks and bonds.

That brings me to Equity Residential Properties Trust (NYSE: EQR) in our Oxford All-Star Portfolio.

Equity Residential owns or has investments in 302 properties consisting of 77,498 apartment units located primarily in Boston, New York City, Seattle, San Francisco, Southern California and Washington, D.C.

It was founded by Sam Zell and Bob Lurie - two of the most successful property moguls in the nation - with the philosophy of investing in properties at the right price and hiring the best people to manage them.

The trust buys, builds and rehabs apartments and condos - for every budget and lifestyle - in growth markets where people most want to live.

The meltdown in home prices during the recent financial crisis took the shine off the idea that everyone should be a homeowner. And in this sluggish economy, many consumers either can’t afford a home or can’t qualify for the mortgage.

So the rental market is strong.

The trust takes in more than $2.4 billion in annual revenue. It enjoys an operating margin of 34%. And you’ll collect a 2.9% dividend here, too.

The executives at Equity Residential are actually looking forward to the Fed raising rates. Why? Because higher rates indicate an improving economy, strong job growth and rising wages. That means increasing demand for industrial space, office space, retail and housing.

- Samuel Taube with Alexander Green

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