Should The Fed Raise Interest Rates? Part I

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Includes: BAC, DIA, IWM, QQQ, SPY
by: EB Investor
Summary

There is much discussion about whether the Federal Reserve should hike interest rates and if so when?

The hawks argue that asset bubbles are sure to form, and thus hiking rates sooner rather than later is advantageous to the economy.

The Taylor rule even indicates that rates should have already begun to rise.

The Efficacy of Monetary Tightening within a Context of Global Economic Instability Part 1: The Hawks' Case for a Rise in Interest Rates

Many investors see interest rates as far too low at this point in the economic cycle, and thus believe that rates should and will rise this year. Bank investors, and Bank of America (NYSE:BAC) investors, in particular, insist in our conversations that rates will rise this year and this will be a catalyst to a stock that has lagged behind their peers since CEO, Brian Moynihan, took over more than five years ago. It seems there is no shortage of individuals who believe in the mantra that rates will rise. Federal Reserve Bank of St. Louis President, Dr. James Bullard, a noted hawk, recently gave a presentation where he explored the need to raise rates and the risks of not doing so.

I believe any discussion about Federal Reserve policy, particularly changing the federal funds rate, must be viewed within a global context. This is because the world is more interconnected now than ever before, and as a result of this, the contagion risks of overseas problems coming to our shores has never been greater. In this three part series, I want to explore both sides of the debate on rising rates and endeavor to demonstrate the efficacy of current monetary policy. The final piece in the series will explore the implications for investors.

The Hawks' Case: Raise Rates Now!

To illustrate the hawks' case, I will use the presentation given by Dr. Bullard, FRB President of St. Louis because I think he makes an interesting case worth consideration, even if you are a dove. Hawks have consistently made the case that keeping interest rates at the zero lower bound for an extended period is inappropriate, especially now when economic conditions have improved markedly. They argue that GDP is rising, and employment is returning to normalized levels.

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They also dismiss current low inflation levels as "temporary" and argue that inflation rates will return to normal, but this begs the question of how temporary are these levels when the market is currently projecting low inflation in the future. Even if the argument can be made that inflationary expectations are temporarily low due to the price of oil or European weakness, this is not a challenge that we recover from overnight. Increases in Oil prices require demand to be put into the equation, which is lacking. Europe's problems are complicated and involve a plethora of cyclical and structural challenges that are not easily cured. Nonetheless, hawks continue to push the narrative of temporarily low inflation expectations and the fact that on a forward basis, inflation expectations are moving closer to trend.

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Another argument used to advocate for interest rate increases is the possibility that the Fed may be choosing to peg the interest rate at the zero lower bound, a concept pulled from the New Keynesian theory's "worst" policy. This is defined as:

"The worst policy is the 'interest rate peg,' under which the policy rate never moves despite changing economic circumstances. In the theory, a key consequence of an interest rate peg is that many different equilibria are possible, including some that may have wide asset-price swings that look like bubbles." Source

The interest rate peg is an interesting economic theory, and the likelihood of its adoption by central bankers is certainly possible, especially during extraordinary policy adoption. This brings up a further question, if rates are pegged at 0% permanently, that is to say any movement of interest rates will disrupt economic activity, and thus rates never move regardless of economic activity, what effect would this have on the formation of asset bubbles, and thus financial crises that result? Hawks would argue that asset bubbles are sure to form, and create a severe draw down in economic activity likely resulting in a recession. This solidifies the hawks' argument that the asymmetric risks of keeping interest rates at the zero lower bound are too large to ignore, and according to the Taylor Rule, rates should have already begun to rise.

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The Hawks' case is thus clear: rates should begin to rise sooner rather than later to avoid the formation of asset bubbles which will ultimately disturb economic activity. But the question remains, what does the data say about whether rates should rise or not? We will explore this in part two of this series.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: This article is for informational purposes only and is not an offer to buy or sell any security. It is not intended to be financial advice, and it is not financial advice. Before acting on any information contained herein, be sure to consult your own financial advisor.