As investors are surely aware, the Fed raised interest rates slightly at its December meeting, likely just the first of several increases. The Federal Reserve last raised rates in 2006, cutting them down to zero in 2008 at the height of the financial crisis. Rates have remained there ever since, as CD savers will attest. Many fear the impact of higher interest rates, but we believe there is much room to raise rates further before the economy is harmed.
Inflation may start to edge up once certain powerful factors cease to have incremental impact. The drastic decline in energy costs held back official measures of inflation, and we haven’t yet felt the full impact on overall prices since energy and transportation are imbedded in the cost of all goods. Prices outside of energy have maintained their steady rise at just under 2%.
Sliding energy prices have had many other impacts. Industrial production has been weighed down by weak orders for oil and gas equipment. Despite a falling unemployment rate, jobs in energy and mining, manufacturing, transportation, and warehousing have been in a flat-to-down trend this year. These tend to be higher paying jobs so their relative softness has hurt overall wage growth. Despite this softness, wages were up 2.3% year-over-year in November, a bit faster than the recent trend. This may have caught the Fed’s attention, signaling that labor markets are starting to heat up. Raising interest rates increases the potential length of the economic recovery by keeping it from overheating.
Falling energy prices were also expected to boost spending as consumers have more money in their pockets. The results aren’t particularly impressive in this regard, and may even appear to be non-existent. Personal income growth has been stronger than consumer spending growth for six straight months. As a result, personal savings rates have improved. An economist’s take would be that consumers don’t yet believe that energy costs will remain low for the long haul and are pocketing, rather than spending, what they perceive to be only temporary savings.
What remains to be seen is how inflation will behave once the dollar and oil prices reach the anniversary of their dramatic shifts. That is to say, will falling unemployment create a scarcity of labor and drive up wages just as the deflationary impact of the strong dollar and plummeting energy prices abate? That is the cost-push inflation curve the Fed is trying to stay in front of by raising rates now rather than waiting to see what happens. Inflation can get out of control once it becomes imbedded in expectations.
Energy prices can’t go down forever. Prices have fallen farther than many thought possible. Oil producers have continued to oversupply world oil markets rather than pull back production in order to stabilize the price. Part of the problem with energy is that the marginal cost of production, the cost of pumping a barrel of oil, is low even though the costs of finding oil and drilling are quite high. Countries that need to feed their people and companies needing cash flow to pay debts are still pumping oil even though it is less lucrative. They will eventually reach the point when they won’t pump additional oil and energy prices will stop declining. A further complication is that Iran will soon be allowed to sell into world markets, adding further to global supply.
The year ahead appears to be fairly similar to recent trends. Relatively low unemployment and low energy costs should keep the American consumer in a buying mood. The dollar remains strong and will hurt the factory sector, but the damage isn’t beyond repair. Low energy prices will likely continue to have a depressing impact on capital spending in the energy industry. And even though interest rates will likely rise, monetary policy will still be in “accommodative” rather than “restrictive” mode. The precarious geo-political situation and the U.S. presidential election will be wild cards, but have historically had only a limited impact on the economy and the markets. In a year of positive economic growth, the U.S. stock market should continue to rise. The presence of many headwinds and generally high valuations will keep market volatility at an elevated level while also holding the rate of advance to a moderate level. Investors should be cautiously optimistic.