What Should the Federal Reserve Do Next?

By Markets Fool.com

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Source: wikipedia

The Federal Reserve has kept interest rates at record lows since the financial crisis. As a result, every time Fed officials speak, the entire market tries to identify clues about when a rate hike is coming.

We asked three of our contributing writers to share their thoughts about what the Fed will do over the next several months. Here is what they had to say:

Dan Caplinger: It's easy for U.S. investors to think that a Federal Reserve rate hike is an obvious decision, especially given how strong the U.S. economy has been recently. Yet when you take a more global perspective, hiking rates could be a huge mistake that could further destabilize global financial markets beyond the pressures that they've already seen lately.

Recent actions in Europe have highlighted the interconnected nature of credit markets in different economies around the world, with European interest rates having fallen to negative levels over the past few months. As a result, U.S. bonds already look more attractive to international investors from a rate perspective than their counterparts from most countries of the world, including both Japan and the members of the Eurozone. That has pushed the U.S. dollar up sharply against the euro and the Japanese yen over the past year, with the euro in particular suffering enough to cause major disruptions in earnings for U.S. multinationals that do extensive business in Europe.

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For the Fed to ignore its global impact on financial markets would be irresponsible, especially given the lack of inflationary pressure to hike rates immediately. Instead, the Fed should do nothing and allow events to play out further before taking dramatic action.

Matt Frankel: I think that the Federal Reserve will err on the side of caution when it comes to raising rates. Tremendous economic progress has been made since the financial crisis, and the Fed is terrified (and rightfully so) of derailing the economic recovery by increasing interest rates too soon or too fast.

Further making the case that it's better to wait, recent economic data has been less than encouraging. The latest GDP data showed that our economy grew at a 0.2% annual rate during the first quarter, well below the 1% that was predicted. In addition, employment growth has recently slowed, and personal spending growth declined to less than half the rate we saw in the fourth quarter.

I do believe that rates will start to rise later this year, but I think it will be slower than most experts project.

When rates do begin to rise, bank stocks stand to benefit more than most. Banks make their money from the spread between the cost of borrowing money (savings and CD interest rates) and the rates they can charge on loans. And, when rates rise, these spreads tend to widen. From an investment standpoint, the banks that should see the biggest benefit are those with a focus on consumer banking, such as Wells Fargoand TD Bank -- though, truth be told,any bank with a significant retail operation should see its profitability increase.

Sean Williams: The latest meeting of the Federal Open Market Committee ushered in an unexpected surprise: a teleconference system. Sure, you could let the "Fed is finally getting with the times" jokes fly, but the move to test a teleconference system with reporters implies that it could raise the federal funds target rate at any scheduled meeting, and not just during meetings that are followed by news conferences.

With the Fed's language becoming more conducive of a hike and all timeframes of a hike essentially removed from its outlook, I believe the FOMC will begin raising rates in three months or less.

Why? Because it's time. Businesses and consumers have had the luxury of record-low lending rates for six years, which has resulted in mass hiring, business expansion, and the ability for businesses and consumers to refinance their debts at incredible rates. Even if the Fed gets aggressive with rate hikes and targets a still low 2% fed funds target within a year, businesses and consumers would still likely be able to nab lending and mortgage rates that are well below the historic average. The U.S. economy has shown it's capable of standing on its own two feet, and I don't believe the excuse of a "cold winter" is going to fly anymore.

If the Fed does get aggressive with its rate hikes as I suspect, businesses which tend to carry substantial cash balances and invest heavily in fixed-income vehicles such as CDs and bonds should benefit in a big way. Here I'm thinking about property and casualty insurer Allstate .

Allstate claimed more than $108 billion in total assets in the first quarter, including $62.4 billion in fixed income securities. Assuming yields do indeed respond in accordance with the FOMC's target adjustments, Allstate could make in excess of $1 billion more per year in investment income if the Fed hit and maintained a 2% target.

The article What Should the Federal Reserve Do Next? originally appeared on Fool.com.

Matthew Frankel owns shares of The Toronto-Dominion Bank (USA). Sean Williams has no position in any stocks mentioned. The Motley Fool recommends Wells Fargo. The Motley Fool owns shares of Wells Fargo. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.