There are mistakes, and then there are mistakes. Misspell a name on a quiz, for instance, and you might get 5% knocked off your grade. Misspell a name on a loan agreement, and you could knock a few percentage points off your share price as investors ponder whether the documents themselves are fraudulent. That's what happened to Nu Skin (ticker: NUS), a skin-care company, earlier this month.
The Federal Reserve has managed to avoid serious mistakes as it slowly brings monetary policy back to something resembling normal. After the initial "taper tantrum" that occurred last year at the Fed's first mention of a reduction in its bond-buying, the economy and stock market have calmed down. Even recent changes to the Fed's language have done little more than keep investors up to date with the central bank's thinking. Thus, no one ought to be caught by surprise when the first rate hike occurs.
Still, one thing the Fed could do at its next meeting, scheduled for this week, would be an error: It could set a timetable for a rate hike. The pressure on Fed Chair Janet Yellen and her team to "do something" has been ratcheting up, as the job market has generally improved and economic growth has strengthened. And the voices inside the Fed that have been calling for a rate hike have grown stronger.
If the Fed were to abandon its data-dependent framework in favor of a firmer timetable before the economy is ready, watch out. "It's worse to tighten when you haven't reached escape velocity," says Dennis DeBusschere, a strategist with International Strategy & Investment Group. "The odds of a potential mistake are increasing."
It isn't hard to see why the hawks might be itching for a rate hike. Just last week, we learned that consumer confidence is at a 14-month high; consumer spending might be a bit stronger than was thought; and the job market continues to heal, despite a slight uptick in jobless claims. And if that were all, setting the course for the first rate hike would be not only understandable but also good for stocks, which tend to follow rates higher if accompanied by stronger economic growth and rising inflation expectations. That was the case starting in June 2004, when the Fed hiked rates 17 consecutive times in two years, while the stock market rose 12%. "The Fed can raise rates gradually, and it doesn't have to be bad for the market," says New York University financial historian Richard Sylla.
Unfortunately, the U.S. economy might not be in that position quite yet. Incomes, if no longer stagnant, are just inching their way higher. Housing remains in the doldrums as potential buyers cite insufficient savings, excess debt, poor credit scores, and, yes, their incomes as stumbling blocks on the road to home ownership. Higher rates won't fix any of those problems, and even setting a schedule for rate hikes could create head winds if it causes loans to become harder to get in anticipation of the change.
The history of central banking is littered with mistakes big and small. There were the Federal Reserve's rate hikes in 1931, which helped exacerbate the early turmoil of the Great Depression, and the rate increases later in the decade that helped prolong it. Looking overseas, we're still shocked that the European Central Bank hiked rates in 2011, doing its part to ensure that Europe's recovery would never gain even the limited traction seen in the U.S.
Even Paul Volcker's decision to hike rates to 19.1% in June 1981 -- more than double what they had been the year before -- initially was viewed as a mistake. And no wonder: Unemployment surged, the S&P 500 tumbled, and farmers tried to blockade the Fed building with their tractors. Still, there's little arguing with the results, as inflation's taming set the stage for a nearly two-decade expansion.
IN THE 1970S, high inflation wasn't just imagined -- it was very real. Today, however, those clamoring for rate hikes seek to head off potential threats -- of higher inflation, asset bubbles, and the like -- and ensure that U.S. growth continues to accelerate. In fact, inflation expectations in the U.S. have been falling recently, not rising. The risk becomes that the U.S. ends up repeating the '70s in reverse. Remember, in that decade, rates weren't hiked enough, causing inflation to reignite quickly, which never solved anything. Today, tighter policy could mean the economy never reaches escape velocity, instead remaining mired at 2% growth. And that's a mistake we don't want to make.
The good news: Stocks could get a boost if yields stay low for longer. Deutsche Bank's David Bianco, for one, estimates that if the yield on the 10-year U.S. Treasury note stays below 4% for several years, it would lower the real cost of equity to 5.5% from 6%. While the change doesn't seem like much, it had a big impact on Bianco's forecasts for the Standard & Poor's 500: He raised his 2014 price target for the S&P 500 to 2050 from 1850, and thinks it could finish next year at 2150, up from 2000.
The S&P 500 closed at 1985.54 last week.