CEO Insight: The Potential Fallout of a Fed Interest Rate Hike

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November’s encouraging labor market report begs the question of not just whether the Federal Reserve will raise interest rates; but whether it will do so at a time when the recovery has peaked, and the economy is heading toward a slowdown?

The labor market added 211,000 jobs in November, bringing the latest 12 month average to 220,000. This 12 month total is better than it was in 2006, the year preceding the Great Recession. Given the growth in jobs and the unemployment rate of 5%, financial analysts are focused on one question – will the Federal Reserve will raise interest rates? The answer is almost certainly yes.

Ironically a second, equally important, question is not being asked. Specifically, has the economic recovery peaked? If so, by increasing the interest rates now, the Federal Reserve may put other brakes on an economy that is about to slow down because it has reached its peak.

Interestingly, the average American sees the ups and downs of the stock market as simply the way life is. However, they believe the economy should always operate on an expansionary path. When it does not, the assumption is that some aberration is at work. In truth, the economy has peaks and valleys like stock exchanges have bull and bear markets. When the potential for further growth becomes exhausted, whether in the stock market or the real economy, investors and business owners become more pessimistic and pull back.

There have been 11 expansions since World War II; each lasted about five years. The current expansion began in June of 2009, just about five and a-half years ago. However,  averages are nothing more than expected values around which real numbers fluctuate above and below. Therefore, it is informative to examine the recoveries that lasted much longer than average. There are three; the first occurred during the Vietnam War, the Internet bubble caused the second, and the third was the result of the housing bubble. No such event exists today; so there is no reason to expect that the current recovery will last much longer than average.

On the other hand, here are five potential fallouts from a Fed Rate Hike:

  1. The unemployment rate dropped from 5.7% a year ago to 5.0% today. One year before the Great Recession, unemployment averaged slightly less than 5%. Implication: although millions of workers are still hurting from the recession, the labor market is about as good as it will get because a rate hike will slowdown hiring.
  2. After years of remaining relatively stagnant, a year ago wages and salaries started to increase. However, consumer have changed their spending habits. The savings rate today (5.6%) is more than double what it was before the Great Recession. Implication: the more consumers save, the less they spend and therefore, retail sales have remained flat. A rate increase will dampen retail sales even more.
  3. Residential construction grew by 16.8% over the previous 12 months, and new home prices rose by 5.6%. This is a good news. The bad news is that the monthly total remains more than 50% below the 2006 pre-recession level. Some of the difference is attributable to the irrational buying and selling that occurred during the housing bubble. The shifting demographics and taste of Millennials in Generation Xers also accounts for some of the difference. However, it is important to note that the low interest rates never made it much easier for the average American to buy or refinance a house. This is because the stiffer financial eligibility criteria caused by the housing meltdown made it difficult or impossible for them to take advantage of the lower interest rates. Higher interest rates will make it even more difficult.
  4. Although GDP growth (2.2% over the last year) is below its long-run trend, the US continues to attract foreign capital because it is one of the few bright spots in the world’s economy. China, Russia, Latin America and the euro zone economies are faltering. The attractiveness of US investments makes the value of the dollar stronger, but it also makes US exports less competitive around the world. An interest rate hike will strengthen the US dollar further and hurt exports more.
  5. Finally, the Federal Reserve typically raises interest rates to put a break on inflation, which there are no signs of today. The consumer price index averaged just .2% last year. It is true, a 17%  decline in the oil price index played a significant role in dampening inflation. However, excluding energy, consumer prices still increased by just 1.9%, an amount that is below the threshold that typically prompts the Federal Reserve to raise interest rates.

The bottom line. There is no easy fix for the dilemma in which the Fed finds itself. Interest rates must increase, but timimg is everything. Realistically, the Fed should have acted long before now ad done so very gradually. After all, the primary beneficiaries of the lower rates were the financial institutions -whose sketchy practices caused the recession. Increasing ates now may cause the fallout to be greater than the benefits; especially if the recovery has peaked. In summary, the Fed should look past the latest employment report and base its action on whether or not the recovery has peaked.

Last modified: June 20, 2017

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