What Will the Fed Do with Interest Rates?

Inflation Rate PCE

What the Federal Reserve does with interest rates may sometimes seem like an esoteric guessing game, but it can affect almost every investment in your portfolio. The level of interest rates directly affects the return you can get on cash, and indirectly affects how stocks, bonds, and many alternative investments perform.

Last week the Fed tweaked the wording of its formal policy statement, paving the way for an end to the era of near-zero interest rates that’s lasted since the global financial crisis. Most analysts currently believe this first interest-rate increase will occur this summer. But even if that comes to pass, the Fed isn’t likely to raise rates very far or very fast. At the end of 2015, and possibly for a while beyond that, the level of interest rates is still likely to be very low by historical standards.

One reason interest rates are likely to stay low is the state of the economy. Though the unemployment rate has tumbled from 10% in late 2009 to 5.5% in February, there are signs that the economic rebound is fragile. The Citigroup Economic Surprise Index, which compares economic data to analysts’ prior forecasts, has fallen into negative territory. The surge in the value of the US dollar against other currencies since late last year may also act as a headwind for the economy by hurting American businesses that sell their products overseas.

The current outlook for inflation also suggests that interest rates won’t rise very far. The Fed’s preferred measure of inflation, called the personal consumption expenditure index, is only 0.2%. The “core” number, which excludes some of its more volatile components, is 1.3%. These numbers are far below the Fed’s 2% inflation target. Even if the inflation rate does slightly increase later this year as the effect of lower commodity prices wears off, there doesn’t seem to be much of a threat of high inflation that would force the Fed to take drastic action.