On July 30, 2014, the U.S. Federal Reserve announced that it would be further reducing its monthly bond-buying program from $35 billion to $25 billion in August and September, with a final round of purchases slated at $15 billion for the month of October. This action of reducing the amount of bonds purchased each month – also known as tapering – first began in January of this year when the Fed reduced its monthly open market purchases (also known as QE3) to $75 billion from a peak of $85 billion.
In some sense, QE3 has been a method of last resort that U.S. policy makers have used to stimulate the economy. With a heavy national debt burden, a sizable budget deficit, and calls for fiscal restraint by the Tea Party, the federal government has had its hands tied in terms of the fiscal policy options available to it in response to a sluggish U.S. economy. Moreover, with the federal funds rate already near zero, the Fed also could do little else to stimulate the economy. The Fed hoped that by buying longer-term Treasury securities and agency mortgage-backed securities from commercial banks and other private institutions, longer-term interest rates would fall in the economy, resulting in a pickup in aggregate demand, and ultimately more robust economic growth. Hence, the Fed chose to engage in an additional round of quantitative easing.
However, two years into QE3, red flags still point to persistent problems in the economy: economic growth has been sluggish, job creation has been anemic, and inflation has been weak. As a result, there were many opponents to the tapering process. To this day, there remain many policy makers and many on Wall Street who want the Fed to delay interest rate hikes until key economic indicators are more encouraging.
But while caution and patience has been repeatedly stressed in the business press, there remain several key arguments for why interest rates must be raised sooner rather than later.
The most important argument for a timely rate hike and a swift end to quantitative easing (QE) is the growing danger of asset bubbles in the US and abroad. Through low interest rates and a growing money supply, the Fed created an easy money environment that ultimately induced an asset bubble in US equities. Case in point: the S&P 500 Cyclically Adjusted Price-to-Earnings (CAPE) Ratio – a widely used valuation metric for the S&P 500 – which is currently over 26, while its historical mean is slightly over 16. It should be noted that since 1881, there have only been three previous periods during which the CAPE ratio was above 25: the years surrounding 1929, 1999, and 2007. Major bear markets followed those peaks. Moreover, the low yield environment caused by the Fed’s policies induced investors to move further out along the risk curve towards other riskier assets (e.g. corporate bonds), ultimately causing asset inflation in other markets as well.
If interest rates are kept too low for too long, there is a real danger of a bursting of the stock market bubble resulting in an unintended hard landing for the U.S. economy; an ironic ending considering the 2007-2009 financial crisis was precipitated by similar easy money policies meant to combat anemic economic growth.
Additionally, while keeping rates low may do well to maintain the economy’s momentum, any prolonged period of low interest rates and/or any subsequent rounds of QE can have a negative impact on business and consumer confidence. Such measures speak to pessimism among policy makers, which may very well undermine the economic recovery.
Furthermore, while the low interest rate regime created by the Fed’s policies did mitigate the worst excesses of the Great Recession, what it effectively did, and has continued to do, was remove a strong incentive for the private and public sector to deleverage their finances. By keeping rates low and pumping money into the economy through QE, debt-servicing ratios were kept low in spite of high debt ratios. As a result, the necessary deleveraging by the private and public sector has been excessively delayed.
Figure 1 Total U.S. consumer debt, stretching back to the first quarter of 2004.
So long as balance sheets remain highly leveraged, it is hard for any sustained economic recovery to take place. In such a scenario, the debt overhang will lead to low private sector spending, low credit growth, and ultimately long-term economic stagnation. Moreover, once interest rates do begin to rise, debt-servicing costs will inevitably rise, which may or may not pose bankruptcy problems in the housing market, considering how high housing debt remains.
Although raising interest rates will put a lot of stress on the current economic recovery, the alternative puts into play too many long-term economic problems whose repercussions will be felt for a very long time.
Our best hope is that an increase in the interest rate will only cause a soft landing for the American economy. Once interest rates rise, consumers will have a tougher time spending on durable goods since more of their disposable income will be spent on debt servicing. Businesses will find it harder to invest in capital goods, and potential homebuyers will find it more difficult to rationalize entering the housing market considering the higher costs of borrowing. The collective effect will likely hamper job creation and take much of the momentum out of the current economic recovery.
However, in the long run, this painful process will precipitate a much healthier and sustainable economic recovery, while spurring economic growth on to new heights. The alternative, long-term economic stagnation, has already been witnessed from afar: Japan over the past two decades.
Let’s hope US policy makers recognize the clear danger the US economy faces if they do not act decisively and swiftly. With this in mind, we welcome Chairwoman Janet Yellen and her team to raise interest rates as soon as possible.
