In the wake of Greece’s debt crisis and China’s stock market crash, Federal Reserve Chairwoman Janet Yellen reiterated the likelihood of an interest rate hike this year. The central banker’s comments came during her semi-annual testimony before Congress.
Dr. Yellen read from a prepared statement, saying, “If the economy evolves as we expect, economic conditions would likely make it appropriate at some point this year to raise the federal funds rate target, thereby beginning to normalize the stance of monetary policy.” (Source: The Wall Street Journal, July 15, 2015.)
At the heart of Yellen’s meandering sentence is huge piece of news: interest rates will probably rise before 2016. At first, this may seem unsurprising. After all, the panel in charge of setting core interest rates, the Federal Open Markets Committee, or FOMC, supported a 2015 rate hike at their last meeting.
But that meeting took place before Greece’s default or China’s stock market crash. Analysts, including myself, were worried that the Fed might reassess their timeline based on these developments.
Bumps Along the Road
Luckily, Chinese regulators were able to stem the outflow of capital. My colleague Jing Pan reported that China banned short-selling and suspended more than half of all stocks from trading. (Source: Profit Confidential, July 9, 2015.)
The stock market run began when they scaled back investors’ ability to buy stocks against borrowed money. After two weeks of sharp losses, China stabilized its market by reversing the ban on margin trading.
Greece is a persistent headwind for capital markets. Its debt negotiations set the stage for a dramatic showdown which ended with the Mediterranean nation almost exiting the eurozone. Fortunately, reason prevailed and Prime Minister Alexis Tsipras reached a deal with Greece’s creditors. On July 16th, the Greek parliament effectively ratified the agreement. (Source: The Wall Street Journal, July 15, 2015.)
I’m hesitant to say the Greek drama is over, but it isn’t an immediate threat to U.S. growth for now.
Higher Interest Rates
The mainstream press seems to talk more about the politics of an interest rate hike than the real world implications. If interest rates are higher, borrowers pay more and debt becomes more costly. That’s the bottom line.
Any financial asset with a variable interest on it will now be worth less simply because asset prices move in the opposite direction to their yields. That means bond prices could fall substantially as companies and governments pay more to their creditors.
Why raise interest rates if it makes debt more costly? Well, there are two broad reasons.
The first thing to consider is market psychology. By keeping the federal funds rate near zero, the central bank was effectively enticing people to borrow and spend. It was meant to stimulate the economy without forcing the government to undertake a fiscal stimulus program.
We’re not sure if it worked in the real economy, but it definitely pumped up the stock market. Markets became incredibly used to the idea of cheap money—but it’s time for a return to normalcy.
And that brings us to the second reason: the U.S. economy is actually improving. There are many reasons to feel optimistic about America’s growth trajectory, especially as it compares with other economies around the world. The Fed’s decision will hinge on economic data, so their upbeat message is a positive indicator on the state of the economy.
“If we wait longer, it certainly could mean that when we begin to raise rates we might have to do so more rapidly,” Yellen said in response to a lawmaker’s question. “An advantage to beginning a little bit earlier is that we might have a more gradual path of rate increases.”