When it comes to evaluating the danger that rising interest rates could potentially have on the US economy, analysts are currently arrayed into two diametrically opposed camps: Fed-induced complacency versus debt-driven pessimism.
1. Fed-induced complacency. Why should Americans worry? The Fed has guaranteed low interest rates at least through the middle of 2015, and perhaps beyond.
2. Debt-driven pessimism. Given the astronomical rise in overall US debt levels in recent years, Americans should worry because if interest rates merely go back up to "normal" levels, the US public and private debt burden will explode. Indeed, a mere "normalization" of interest rates could jeopardize the current economic recovery.
In many ways, I believe both positions are wrong - not because they are extreme, but because they are focusing on the wrong issues.
Why Fed-Induced Complacency Is Wrong
The reason why Fed-induced complacency is wrong is very simple: The Fed does not ultimately control interest rates in the US. To understand why the Fed does not ultimately control interest rates, it is helpful to understand the two main ways that the Fed can influence them under certain circumstances.
1. Fed funds. The Fed controls an interest rate called the Fed Funds rate, which is a short-term interest rate. This is a short-term interest rate that banks can fund themselves (i.e. borrow money from the Fed) and it represents a miniscule portion of the overall credit market. Nevertheless, this interest rate tends to influence short-term interest rates throughout the economy for reasons that cannot be fully expounded on here. By contrast, the Fed Funds rate has relatively little impact on medium and longer-term interest rates. Indeed, it could be credibly argued that long-term market interest rates influence the Fed Funds rate more than vice-versa. Why?
The Fed Funds rate places no restriction whatsoever on the short or long-term interest rates credit providers charge to their customers. Banks and other credit providers are free to change whatever interest rates the market for credit can bear. Thus, for example, if the demand for credit surges due to robust economic growth, banks can charge higher interest rates (despite funding themselves via the low Fed Funds rate). Additionally, if inflation rises, credit providers will charge more for credit regardless of what the Fed Funds rate is, because they know that the money they will be paid back with in the future will be devalued by said inflation and/or because they expect funding costs in the future to rise. Long-term interest rates will be especially sensitive to inflation expectations. Indeed, long-term interest rates can spike if market participants perceive that the Fed Funds rate is excessively low.
2. Quantitative Easing (QE): The Fed can "create" money and use it to purchase debt securities on the secondary market, thereby placing upward pressure on the prices of such securities and downward pressure on their yields. However, the Fed's power to influence interest rates in this way is, in practice, extremely limited. First, the size of the Fed's balance sheet is utterly insignificant in relation to the total global market for US dollar denominated credit. This means that the Fed - via money supply measures such as QE - is powerless to prevent interest rate increases that stem from major shifts in the demand for US dollar-denominated debt securities. Second, there are practical limits to how much the Fed can engage in QE without defeating its own purposes. At a certain point, expansion of the Fed balance sheet (to counteract declining demand for US dollar denominated debt) would trigger a self-defeating vicious cycle whereby asset purchases provoke a rise in inflationary expectations, thereby causing a flood of sales of US Dollar denominated debt securities, which if met by further Fed purchases (i.e. monetary base increases) to repress yields would only trigger even greater increases in inflationary expectations.
The Fed simply cannot successfully contain interest rate rises through the mechanism of QE in a context of accelerating inflationary expectations.
In sum, the widespread notion that the Fed can prevent interest rates from rising at will is false. Regardless of Fed policy or intentions, interest rates will rise significantly if either of two events occur (or both): A) Increased economic growth. B) Rising inflationary expectations. The Fed is essentially powerless to prevent this. Indeed, under such circumstances, the Fed must either rise interest rates itself in response to market forces, or it will lose any marginal influence that it can exert on the process.
Why Debt-Driven Interest Rate Pessimism Is Wrong
Many analysts believe that given high debt levels in the US, rising interest rates would be fatal to the economy.
I think it is beyond question that all things being equal, rising indebtedness in the US in recent decades has made the US economy increasingly vulnerable to rises in interest rates. All things being equal, higher debt means that the economic drag caused by higher debt service increases.
Having said that, many analysts tend to be too pessimistic regarding the ability of the US economy to withstand a normalization of interest rates. For example, let us assume a 200 basis point increase in long-term interest rates as a result of a more robust economic recovery.
1. Public sector debt service. Contrary to popular belief, a 200 basis point rise in long-term interest rates will not cause interest costs or the US deficit to balloon in the short-term. It should be remembered that a large portion of US debt is locked in at historically low interest rates. Furthermore, the debt that does mature can be managed in such as way as to blunt the impact of rising interest rates. For example, maturing long-term high interest debt can always be paid off with financing from low-interest short-term debt.
2. Corporate sector debt service. In terms of the corporate sector, debt is low, liquidity is high, and 200 basis points of higher interest rates would, on aggregate, be unlikely to derail investment projects (including new hiring) spurred by the prospect of a more robust economic recovery. Indeed, the macroeconomic impact of investment projects made unviable by a rise in interest rates would be offset by projects made profitable by the prospect of more robust economic growth.
3. Household debt service. Household consumer credit rates might rise a bit if long-term interest rates rise - although this is far from clear. However, even so, the wider availability of credit sparked by a more robust economic recovery would tend to cancel out any negative macroeconomic impact from rising rates.
The household sector would mainly be negatively impacted by higher long-term interest rates via the rise in variable mortgage rates. While this would be a blow to many households, it is also true that the macroeconomic impact of more robust economic growth via greater employment, rising incomes and greater consumer confidence would largely offset this negative effect. Furthermore, US banks have been doing a very good job of writing off and provisioning for the potential losses in their sub-prime variable-rate portfolios. Thus, the impact in bank balance sheets of rising delinquency in these sectors, while substantial, would not be catastrophic. Indeed, a growing economy would raise asset quality and recovery rates elsewhere in banks' portfolios.
Therefore, while the impact of rising interest rates would not be negligible and will likely act as a restraint on economic growth, it is unlikely that interest rate normalization caused by more robust economic growth, in a context of low inflation, would actually derail the economic expansion.
Inflation Is The Wildcard
Let us review what has been said thus far: Regardless of the Fed's good intentions, interest rates will, in fact, rise if either of two things occur: Faster economic growth and/or rising inflation. On the other hand, it is not likely that an economic expansion will be derailed by a normalization of interest rates caused by an accelerating economy.
Therefore, the main remaining risk factor that could derail an economic recovery via higher interest rates would be rapidly accelerating inflationary expectations. Let us see how such a scenario could play out.
Please note that core inflation (CPI minus food and energy) is currently at around 2.0% -- the level that the Fed has for the past twenty years declared to be the limit of its "comfort zone." Let us assume a substantial acceleration of core inflation towards the 3% range - hardly a far-fetched assumption. This could occur via mechanisms such as internationally priced resource price increases, more robust utilization of resources in certain sectors and dollar weakness in FX markets. What would the Fed do? What could it do?
On the one hand, the Fed has expressed confidence that it can quickly remove excess liquidity from the system. I believe that this is absolutely correct.
On the other hand, it is also true that under conditions of accelerating inflation, such an "exit" would pose extraordinary risks to interest rates and economic stability generally. Why? First, under such circumstances, market interest rates would rise organically in response to rising inflation. Second, credit markets could suffer a "double-whammy" in that simultaneous to the organic rise in interest rates in response to accelerating inflation, the Fed would be virtually obligated to sell securities in their portfolio in order to drain liquidity from the system, thereby exacerbating the rise in interest rates.
Such a sale of Fed securities would simply become the mirror image of QE (which might be dubbed QT for "Quantitative Tightening") and would place upward pressure on interest rates above that which might have arisen organically from an acceleration of inflation under normal conditions.
Thus, the rise of inflation would threaten the economy precisely at a time when the Fed was rendered completely lame to act in a countercyclical fashion. The Fed would be in a lose-lose situation. On the one hand, if the Fed failed to withdraw liquidity from the system in the face of accelerating core inflation (thereby squandering its credibility vis a vis markets), inflationary expectations and interest rates would only accelerate further. On the other hand, if the Fed elects to preserve its commitment to low inflation and therefore withdraws liquidity, this sort of "QT" would actually exacerbate a spike in interest rates. And such a "double whammy" interest rate spike could, in fact, be sufficient to derail an economic recovery in the context of a highly indebted economy.
A normalization of interest rates will not necessarily derail an economic recovery. If interest rates rise in a context of accelerating economic growth and muted inflation, a recession will probably not result.
However, if rising interest rates are the consequence of even modestly accelerating inflation, all bets are off. At that point, the long-dormant so-called "bond vigilantes" (which are nothing more than ordinary investors that sell their bonds to protect themselves against inflation) will take over and the Fed - whose real powers are quite limited - will be forced to bow to the sovereignty of market forces and essentially join the bond vigilantes in orchestrating a rise in interest rates.
Please note that I am not currently predicting an acceleration in inflation. What I am saying is that with core inflation already above a key benchmark that the Fed has staked its credibility on, the risk of interest rate instability is very real. It should be of concern to investors that despite economic growth being so anemic and overall resource utilization being so low (including human resources) there is currently very little margin for error on the inflation front. In such a context, economically sensitive and/or cyclical stocks such as Intel (NASDAQ:INTC), Freeport-McMoRan (NYSE:FCX) or Dow (NYSE:DOW) or index ETFs representing broad stock indices such as (NYSEARCA:SPY), (NYSEARCA:DIA) or (NASDAQ:QQQ) are vulnerable to significant declines.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.