After several years of historically low interest rates, the Federal Reserve declared intentions for a rate hike this year, barring an economic slowdown. That’s why you can bet Janet Yellen and her fellow policymakers are closely monitoring China’s stock market crash and its impact on U.S. stocks. Recent data points show conflicting outlooks for economic growth, leaving markets divided on whether or not the Fed will continue as planned.
To get a better sense of how this will play out, I sat down with my colleague and macro specialist, Gaurav S. Iyer.
Prazic: Gaurav, can you explain why the Federal Reserve wants to raise interest rates?
Iyer: Sure. There are a few reasons, but mainly I get the sense that Janet Yellen is uncomfortable with bankrolling economic growth. If you look back at the financial crisis, we had no idea how far the market could fall. We had no idea much the economy would suffer, so it made sense for the Federal Reserve to intervene. They put a floor on the market and that was great. But since then they’ve added $4.0 trillion to their balance sheet to get the economy back on its feet. Now they want to see if it can stand without their support.
Prazic: It always shocks me to hear the $4.0 trillion figure. How and why did the Fed manage to spend that much?
Iyer: Well, $85.0 billion a month on asset purchases will run up a pretty high tab. The Fed was buying low-quality bonds from distressed banks to get them into a better financial position. But by doing that they added heavily to the supply of money. The hope was that new money, plus rock-bottom interest rates, would create an environment for banks to lend and businesses to spend. And all the spending would translate into higher employment and economic growth. However, the data doesn’t support that story.
Prazic: But we’ve seen U.S. stock indices hit all time highs. Doesn’t that help the Fed rationalize a rate hike?
Iyer: Actually the stock market highs the most compelling evidence against raising interest rates. When we talk about the economy, it’s important to distinguish between the real economy and the financial economy. Stocks and bonds comprise the financial economy, but the real economy is what’s happening on the ground. So we look at retail sales or inventory turnover. Those haven’t exactly been encouraging, and I’m not the only one who sees that. The Congressional Budget Office lowered their growth forecast for 2015 to two percent from their 2.9% estimate back in January. The International Monetary Fund (IMF) also cut their expectations for U.S. growth. But somehow those facts get buried in a sea of stock market optimism.
Prazic: Are you saying the stock market is overinflated?
Iyer: Absolutely. The gains made over the last few years are hollower than Wall Street is willing to admit. It’s amazing how quickly they forget their own powers of self-delusion. As late as 2007, the keepers of conventional wisdom would have laughed if you suggested the stock market was going to crash. And up until last week, they’d gotten back to feeling invulnerable. Then we saw a five percent drop on Friday and the market plunged again on Monday morning.
Prazic: What’s the endgame? Will the stock market crash?
Iyer: So there’re two possible scenarios: we can either grow into the bubble or it can collapse around us. And which scenario we end up in depends on the Fed’s next move.
Prazic: OK, let’s say the Fed doesn’t raise rates because of China’s stock market crash and weak economic indicators at home. Which scenario does that get us?
Iyer: Ironically, I see that ending in a crash. At this point, seven years deep into the recovery, one thing has become clear: monetary policy is useless at creating growth in the real economy. Or at least it’s useless in this recovery, because we’re stuck in what economists call a liquidity trap. We’re so used to the idea of “easy money” that no amount of monetary stimulus will get us spending in the short term.
Prazic: So where does that leave us? Will the Fed raise interest rates this year?
Iyer: I think they have to. Central banking is about managing expectations, and the market has priced in rising interest rates. A lot of people say the Fed could lose credibility if they don’t follow through on their promise. I think that’s right, but it goes deeper than that. The Fed has actually staked America’s reputation on this rate hike, because the increase is conditional on an improving economy. If they don’t raise the rate now, they’d be saying the U.S. economic outlook is terrible. But I think the increase will be small and will only come in December.
Prazic: Thanks for sitting down to chat, Gaurav.
Iyer: No problem. This was fun!