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Affluent Investor | June 23, 2017

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Why The Fed Can’t Raise Rates

Unemployed

The VIX (volatility index) is in a coma, so most investors are dozing while danger signs about the current stock market pop up. The idea that the Fed causes recessions by raising interest rates has relaxed many investors. Some writers have assured nervous investors that it won’t be until the Fed’s third rate increase that the market will respond.

In this previous post, I used Hayek’s Ricardo Effect to explain that recessions can happen without rising interest rates. Now, Hoisington Investment management adds support for Hayek from a different perspective. In the Quarterly Review and Outlook for the first quarter of this year, Hoisington wrote about the financial histories of nations with over-indebted economies. That history goes back two thousand years, but the US has suffered through four such seizures in the 1830-40s, 1860-70s, 1920-30s and the past two decades. The report offers six characteristics of excessive debt:

  1. Transitory upturns in economic growth, inflation and high-grade bond yields cannot be sustained because debt is too much of a constraint on economic activity.
  2. Due to inherently weak aggregate demand, economies are subject to structural downturns without the typical cyclical pressures such as rising interest rates, inflation and exhaustion of pent-up demand.
  3. Deterioration in productivity is not inflationary but just another symptom of the controlling debt influence.
  4. Monetary policy is ineffectual, if not a net negative.
  5. Inflation falls dramatically, increasing the risk of deflation.
  6. Treasury bond yields fall to extremely low levels.

I placed in bold part of item #2 for emphasis because of its relevance to this year. Most investment analysts fear only the bogey man of rising interest rates, as Hoisington wrote:

Many assume that economies can only contract in response to cyclical pressures like rising interest rates and inflation, fiscal restraint, over-accumulation of inventories, or the stock of consumer and corporate capital goods. This idea is valid when debt levels are normal but becomes problematic when debt is excessively high.

Since Ms. Yellen had hinted that she won’t raise the Fed’s rate until the end of the year, analysts assume they have a cloudless sky in which to fly. But I agree with Mr. Hoisington, whose returns on bonds embarrassed those in stock markets in 2014, that the Fed will be unable to raise rates for many years, maybe decades.

The real bogey man is another recession that is likely this year, in which case bond yields will fall like a clown’s baggy pants and shock analysts, only they won’t laugh. For if inflation turns to deflation of -1%, which is likely in a recession, and nominal yields on bonds are 1.5%, then the real yield is 2.5%. In such a scenario, long term US government bonds will outperform just about anything else.

  • Not_Easily_Impressed

    It seems to me, you make a valid point about most investors and analysts “out there”. They don’t seem to understand that it is possible to have a “recesssion” or cut-back in economic activity without first seeing the rising interest rates in various financial instruments. You make a good point. Second, it seems to me, you make a valid point about interest rate setting by the FED. They can’t raise rates and the won’t raise rates. Good point. I agree. Now I get to the point where I disagree. Perhaps it is just perception, but it seems you buy into the idea that the FED controls, or can control, interest rates. If they did, then they could keep rates low for 30 years and a 30-year bond would be a great investment. Right? Well, put that way, the fallacy should be obvious. So, some poor sucker buys your 1.5 percent, blah, blah, blah, and then what?

    Okay, now that you have a hint as to where I am going, here’s the bottom line. The FED does not “control” interest rates and they don’t “control” inflation. It all has to do with what millions of individuals do and think. When enough people get their dander up and “sell” dollars for other assets, dollars will be “lose” purchasing power and your paper will be worth less, or worthless. (ha ha) US government bonds will NOT outperform, the exact opposite of your (phony) conclusion.

    • baergy

      Exactly! The market still sets the interest rate. The only thing the Fed can do is set a target and make waves! The one and only interest rate the Fed can set is what it will pay banks for their excess reserves.

  • Anybody that does not grasp that we live in massive illusions and the economy is just another one, is not paying attention and will be a victim.

  • billzehner

    Most economic expansions last 5-8 years and are followed by contraction. The current expansion has begun its seventh year and we should expect a recession to begin shortly. Furthermore, the last 4 government administrations – Carter, Reagan-Bush, Clinton, and Bush have ended in recession. I do not expect, this administration to end that streak. Furthermore, I believe that Yellen may be thinking along these lines also. That translates to no Fed interest rate hikes until the next economic recovery.

    • Karll

      When did we ever expand since 2008?
      Historically, recoveries have equaled recessions in size.
      Small recession, small recovery.
      Big recession. big recovery.
      We have barely recovered from The Great Recession.
      This govt has strangled the recovery.

  • Karll

    I recall most economists agreeing that a debt-to-GDP ratio of 50% or less is okay, but above that is dangerous. We’ve gone to 100+% under barry.

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