The Fed Should Not Raise Rates - They Are High Already
- Currently, with inflation being zero, real interest rates are not low at all.
- Raising interest rates will do nothing but add more deflationary pressures to the US economy, and hurt exporters.
- The only thing that can be done to help the economy is to adjust and improve fiscal policies.
Currently there is a huge dilemma in the economies of the developed world, a dilemma that existed in Japan for more than two decades, which seems to be currently a plague for the whole world - how do we get inflation going? There may be a dilemma also related to low interest rates as well, but that is a consequence of the lack of inflation. Is any economy destined, eventually, to reach a point in which inflation, as it is currently defined and measured, is zero and interest rates almost zero? That's still an open question. It probably all depends on how you treat monetary policy, and how much money you are willing to print. But would that be a bad thing, to have close to zero interest rates? What is really wrong with it? Theoretically, when you have close to zero, or even zero, interest rates, doesn't that mean money has no time value anymore and that labor is the only possibility left to earn a living?
Well, unfortunately it doesn't. Here comes inflation, which ruins the whole idea. Back in 2007, when 10-year US treasuries yielded almost 5%, inflation was 4%. That left a REAL interest rate of just 1%.
Now, in 2015, thanks to external factors like the money-printing in Europe and Japan, the slowdown in China, and the crash in commodities markets, inflation is around zero. The 10-year US bonds yield 2.1% per annum, which means 2.1% REAL returns - higher than it was back in 2007. So, apparently, the holder of capital earns more than 2% in real terms now, while he only earned 1% in real terms in 2007.
Why does the Fed want (or rather seems to desire) to raise interest rates then? There is no inflation out there, and all you can (theoretically) do, raising interest rates, would be to add to return on money, while it is quite high already. It is true that interest rates are at their current levels of around 2.1% for the 10-year Treasuries simply because the market anticipates that rates will rise relatively soon (as the Fed want the market to believe). Otherwise it would normally fall, probably, to 1.5% or lower, depending on how distant the market would believe a REAL (not just words) rate rise would be.
This low inflation environment, which seems to beguile Fed officials, may be the result of some new factors, which may not be as temporary as many economists believe. Europe is facing a shrinking population, just like Japan. China is facing an industrial recession, which is deflationary. Therefore, Europe, Japan, and recently China, are not adding to inflationary pressures in the world. However, Europe and Japan, by printing more money, are doing practically nothing but exporting some of their deflation to their trading partners, US and China more precisely. And smaller trading partners (other emerging markets like Russia, Brazil, etc) are facing their own economic problems, mostly because of the crash in commodities.
And now, the US, as the Fed suggested a few days ago, is again thinking about raising interest rates. In case the US will indeed raise interest rates, and Europe and Japan will maintain their current QE programs, or perhaps even add to them (as the ECB hinted recently), the only consequence will be that even more deflationary pressures will be exported to the US as the result of a tighter monetary policy of the US dollar. I strongly doubt long term interest rates in the US will rise. They may even fall shortly after the interest rate hike because of the looming below zero inflation rates. As economic conditions stand right now, hiking interest rates will do nothing to the US economy other than hurting its exports, and therefore hurting the whole economy. The US dollar may not get much stronger, as it is already strong enough to reflect an impending rate hike. What will happen though will be an accelerated rate of deflationary pressures from all the other major trading partners in the world.
Nonetheless it is unlikely a premature rate hike will be able to stand the test of time. It will most likely be reversed relatively soon. There is no sign of any inflationary pressures appearing anytime soon anywhere in the rich world. The only thing that has happened in 2015 has been a fall in inflation across the world, and of course including the US. Inflation was quite decent in the US up until last year, but when Europe started its own gigantic QE, and when commodities markets crashed, there was no way inflation would pick up any time soon. And I don't see how it can happen in the first two quarters of 2016, as the US economy itself might lose steam. The US has had a decent period of economic growth already, since 2009, and a cycle of relative deceleration cannot be ruled out.
It just seems to be a new world of no inflation for now. You add China to the world economy, where economic cycles are not exactly the same as those in the developed world (because of its strong capital controls), and things get even more gloomy for inflation. China still has a lot of room for monetary stimulus, as it can further lower its interest rates, or even further weaken its currency.
Although I do not believe it will weaken its currency in any meaningful way, China is by no means going to add to inflationary pressures in the world for the coming quarters. Chinese tourists and domestic consumers, buying iPhones and other imported goods, are indeed adding to inflationary pressures in many of the world's developed markets, but China's more traditional exporters are equally busy adding to deflationary pressures everywhere in the world, either by selling ever cheaper products, or by having significantly reduced their imports of raw materials.
US politicians, and Fed officials alike, should think about the new economic realities of the world and start considering measures to improve the fundamentals of the US economy through sound fiscal policies rather than wasting time about low interest rates. There is no threat whatsoever from low interest rates at the moment, because real interest rates (adjusted to inflation) are quite high already.
There is a lot of room to improve fiscal policies in the US (and even more in most other developed countries, like Europe and Japan) and it is rather a good period of time that nominal interest rates are historically low, which reduces the cost of servicing debt. The US with the strongest entrepreneurial spirit in the developed world, and still a growing population, can hugely benefit from better fiscal policies, to improve productivity and output. And of course there is absolutely nothing wrong in low interest rates (which, as I showed earlier, isn't low in real terms) to help reduce the burden on the government.
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