Currently economists and market watchers roughly fall into two camps: Those who believe that the Federal Reserve must begin raising interest rates now so that it will have enough rate cutting firepower to fight the next recession, and those who believe that raising rates now will simply precipitate an immediate recession and force the Fed into battle without the tools it has traditionally used to stimulate growth. Both camps are delusional, but for different reasons.
Most mainstream analysts believe that the current economy can survive with more normalized rates and that the Fed’s timidity is unwarranted. These people just haven’t been paying attention. The “recovery” of the past eight years hasn’t been just “helped along” by deeply negative real interest rates, it is a singular creation of those policies. Since June 2009, when the current recovery began, traditional economic metrics, such as GDP growth, productivity, business investment, labor force participation, and wage growth, have all been significantly below trend. The only strong positives have been gains in the stock, bond and real estate markets. We have had an “asset price” recovery rather than a bona fide economic recovery. This presents unique risks.
Asset price gains have been made possible in recent years because ultra-low rates have driven down the cost of borrowing, encouraged speculation, and pushed people into riskier assets. Donald Trump was right in the presidential debate when he noted that the whole economy is “a big fat ugly bubble.” Any rate hike could hit those markets hard across the financial spectrum and can tip the economy into contraction. Look what happened this January when the market had a chance to digest the first rate increase in 10 years. The 25 basis point increase in December 2015 led to one of the worst January's in the history of the stock market. Since then, the Fed has held off from further tightening and the markets have treaded water. There is every reason to believe that the sell-off could resume if the Fed presses ahead.
Our current “expansion,“ which began in June of 2009 is 88 months old, and is already the fourth longest since the end of the Second World War (post-war expansions have averaged 61 months) (based on data from National Bureau of Economic Research and Bureau of Labor Statistics). But although it is one of the longest it has also been the weakest. Despite fresh optimism nearly every year, we have not had a single year of 3 percent GDP growth since 2007. More ominously, the already weak expansion is beginning to slow rapidly. GDP growth has been decelerating, averaging just 1% in the past three quarters. (Bureau of Economic Analysis) And while hopes were high for a significant rebound in Q3, as has been the pattern all year, rosy estimates have recently been sharply reduced.
Typically rate-tightening cycles start in the early stages of a recovery when the economy is still gathering momentum. As I have argued before, a rate tightening campaign that begins in the decelerating tail end of an old and feeble recovery is bound to unleash problems.
So I agree with those who believe that rate hikes now will bring on recession, but I disagree that we should keep rates where they are. They believe we need to keep the stimulus pedal to the metal…and when that’s not enough, to cut a hole in the metal and push harder. I believe that despite the short term pain that will surely follow, we need to raise rates now to break the addiction before it gets worse.
The “keep rates at zero camp” argues that global economic developments have made traditional GDP growth nearly impossible to achieve. These believers in “the new normal” fear that the Fed is mistakenly waiting for growth that will never come. Larry Summers, the leader of this group, recently argued in the Washington Post that the Fed will never be able to raise rates enough in the short term (without plunging the economy into recession) to gather enough ammunition to effectively fight the next recession. In his view, to raise rates now would be to risk everything and get nothing.
Summers knows that central bankers now do not have the caliber of bazookas that their predecessors once carried (Bernanke was able to slash interest rates over 400 basis points in a few months). So he advocates continued stimulus until newer means can be developed to head off the next recession before it develops. (He promises to reveal those new ideas soon…really).
Given all the economic realities that central banking has attempted to suspend in recent years (such as the antiquated belief that lenders should be paid to lend rather than being charged for the privilege), it’s no great stretch for them to consider the next big leap and call for an age of permanent expansion.
