Rate Hike

On December 16th, the Fed hiked interest rates for the first time in nearly 10 years. The world did not come to an end, but there are likely to be problems ahead.

Fed Chair Janet Yellen gave three main reasons for the 0.25% increase in the Federal Funds rate. First, the economy has recovered enough to withstand higher interest rates, so the Fed wants to begin the process of "normalizing" interest rates. Second, if the Fed doesn't begin normalizing rates, there is a risk that the economy will overheat. In that case, the Fed would have to hike rates even more aggressively to prevent inflation from rising too sharply; and that could possibly cause a recession. And, finally, the third reason: Holding the Federal Funds Rate too low for too long could encourage excessive risk-taking and thus undermine financial stability. I think it was this reason that was decisive. They are afraid a bubble is forming again; and they felt that they needed to act before the bubble grew too large.

The Fed had been signaling this rate hike for so long that the financial markets took the news pretty calmly. Nevertheless, it is generally understood that there will be negative consequences. The Fed has indicated that it is likely to increase interest rates by a further 1.0% in both 2016 and 2017. So long as rates continue to rise, the US Dollar will continue to strengthen. A stronger Dollar will push down commodity prices and cause more pain for the commodity producing countries, from Brazil to Russia to Australia and beyond. The economies and currencies of those countries are likely to weaken further as a result. The stronger Dollar will also negatively impact US manufacturers and reduce US exports.

Rising interest rates are also likely to cause credit growth in the United States to slow. That is a worry because credit growth is the main driver of economic growth - and credit growth is already quite weak to begin with.

The biggest danger, however, is the risk that higher interest rates will cause asset prices (such as the price of stocks and property) to decline. Since 2009, the Fed has managed to make the US economy grow by printing money and pushing up asset prices. Household sector Net Worth is now $86 trillion. That is $18 trillion (26%) more than it was at its pre-crisis peak; and $30 trillion (55%) more than at the crisis low. This newly created wealth has allowed many Americans to spend much more than they otherwise could have. Now, however, if interest rates continue to rise, asset prices are more likely to fall than to continue inflating. This is of particular concern because asset prices are already very stretched relative to income. This suggests there is a bubble in asset prices and that they are vulnerable to a correction. Since 1952 the average for the Wealth to Income Ratio has been 526%. Every time it has exceeded 600% there has been a major correction. At the end of September the ratio was 631%; and it has moved higher since then.

Finally, I don't think we have seen the end of 0% interest rates. Since the early 1980s, every time there has been a recession, the Fed has responded by cutting the Federal Funds Rate to a lower level than the time before. During the recession of the early 1990s, the Fed cut rates to 3.0%. Ten years later, after the NASDAQ Bubble popped, they cut to 1.0%. In 2008, rates were cut to 0%; and, when that was not enough, Quantitative Easing was introduced to provide even more monetary stimulus. The next recession can't be that far away. When it arrives, don't be surprised to see the Federal Funds Rate back at zero and even greater quantities of Quantitative Easing.

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