The Federal Reserve has never maintained interest rates so low for so long over the course of modern economic history: they have been close to 0% since 2007, in reaction to the economic crisis of the time and the weak recovery since then.
Temporary measures have become the norm: the Fed today buys $85 billion of U.S. Treasuries (NYSEARCA:TLT) and mortgage securities per month in order to stimulate the economy. It has announced that it would not cease to use this unconventional monetary policy until the unemployment rate drops to 6.5% (it is currently 7.6%). Even though these emergency measures have been necessary, they are also dangerous.
Firstly, let us highlight the good management of Ben Bernanke, the Federal Reserve's chairman since 2006. Given his experience as a macroeconomist focused on the crash of 1929 and monetary policy, it would have been difficult to find someone better equipped to head the Fed over the past few years.
The 'Bernanke put', or the automatic decrease of interest rates during periods of markets weaknesses, seems to have had a positive effect on the economy, even though the latter still remains wobbly. Investors' optimism increased over the past months, on every scale. The Dow Jones Industrial Average (NYSEARCA:DIA) and the S&P 500 (NYSEARCA:SPY) indices both reached a new all-time high and have more than doubled since 2009. 'Mega deals' are taking place again, such as the announced buyouts of H.J. Heinz (NYSE:HNZ) and Dell (NASDAQ:DELL). Retail investors are plunging back into the stock market, and residential real estate has regained strength. In light of this, households are more confident and feel wealthier, have increased their spending and started borrowing again, for some.
Even if inflation has not occurred yet, the current monetary policy can be cause for worry. Several credit markets have taken off and risk tolerance has grown among investors. In particular, the junk bond (high yielding bonds rated 'speculative' by rating agencies) and leveraged loan (loans to companies already having a substantial amount of debt on their books) markets can become artificially inflated. Any speculative bubble could threaten the shaky health of the economy. Some 'exotic' securities and structured products that had disappearing for a few years are reappearing on Wall Street (what can be a good thing, as long as they serve their intended purpose, which is the help hedge risk).
Furthermore, even though large corporations borrow easily at extremely low rates, overall, credit is still difficult to access for many. Banks are still lending in a limited fashion, and the liquidities injected in the economy by the Fed sometimes do not reach past the banking system. In this case, the Fed's cash is used to recapitalize financial institutions' balance sheets, and that mandatory equity raise was imposed by the Fed. On the other hand, lenders are now in a much better financial situation than several years ago. Citi (NYSE:C) is no more on the brink of collapse, J.P. Morgan (NYSE:JPM), expect for a trading loss, is still perceived as strong, and AIG (NYSE:AIG) might this year seek to pay dividends again.
In the medium run, the Fed will have to overcome significant obstacles in order to continue guiding the economy towards full health. It has used extraordinary measures, never used before, and the consequences are yet unknown. The economy is still under perfusion, and the Fed autocorrects daily its guidance based on the information it receives.
The Federal Reserve will absolutely have to show it is capable of handling well its monetary policy exit smoothly so that no sharp market volatility occurs when the day to increase interest rates comes. The change in monetary policy will have to take place when investors will have regained sufficient confidence in the economy. Beforehand, any premature decision by the Fed risks weighting heavily on stock prices, and could thereby have an impact on the consumer, who still bears the scar of the 'Great Recession'. Nevertheless, the Fed cannot wait too long before raising the rates, or it might favor the creation of financial bubbles.
When will the rates rise? That is the question. The March job report has been weak: even if unemployment has slightly dropped, it did so because of workers abandoning their job searches and dropping out of the workforce. This should give a reason for the Fed to keep rates close to 0% over the next few months. But lately, the Fed's board members have been split on what monetary policy to adopt and when to do so. Voices have risen to stop pumping liquidity in the banking system. We can therefore expect rates to rise in early 2014, if unemployment drops significantly before the end of the year.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.