The fear mongers are out in force. Since job numbers have been improving, everyone seems certain that interest rates will rise. What does that mean? Just perusing Yahoo! Finance, rate hikes seem likely to tank stock markets and housing prices. After all, conventional wisdom says stocks are high because bond yields are low, and housing prices are high because interest coverage costs are low. Raise rates, tank asset prices, right?
First of all, as Scott Sumner reminds us, never reason from a price change. Stock prices may be high because of low rates. But increasing (and steady) demand growth are big reasons why as well. When stocks crash, they are most likely forecasting an economic downturn. Between World War II and the 2008 financial crisis, economic downturns were engineered by the Federal Reserve to quash inflation. The 2008 crisis was an exception in that the Fed tightened policy even as nominal GDP growth fell. But since they’ve (hopefully) learned their lesson since then, and with low inflation as far as the eye can see, we should have a very long run of economic growth. This is especially true as we’re still below trend.
And house prices? Most commentators “believe” in the bubble of 2008, but refuse to look at other countries like Canada, the United Kingdom and Australia where housing prices never fell like in the US. The difference? Their respective central banks didn’t tighten. They let inflation rise instead of choking aggregate demand. So stock market investors and home buyers could rely on a steady increase in nominal GDP. Not too much to cause rampant inflation, but enough to lower real wages / real debt levels to bring markets back towards balance without the harsh restructuring happening in continental Europe.
Never reason from a price change. Just because interest rates (or the dollar) rise doesn’t necessarily mean policy is tightening. But don’t fall for the fallacy that the Federal Reserve has complete control over where interest rates go either. A lot of folks have lamented that repeated rounds of QE and long-term ZIRP as market-distorting aberrations. If we could only raise rates to a “normal” level, the economy would be fine. Savers would finally get their just rewards.
But interest rates aren’t just enforced from on high by the Fed. They are also the market-determined cost of capital. Since the financial, crisis consumers have de-leveraged, banks have sat on deposits, and public corporations have bought back stock rather than invest in new production. Why? Because there’s not enough demand for borrowing and too much supply of savings. So interest rates should be at historic lows. Will they pop up again soon? Away from the insanity of Yahoo! Finance stories, I found an article talking about the super-cycle in interest rates. To make a long story short, interest rates don’t move that quickly. This makes sense as inflation expectations don’t move that quickly (unless by some external shock or some massive policy error by the Fed).
Just look at the chart below, which covers 141 years of 10-year treasury rates. In “depressed” times, interest rates take a long time to bottom. As the financial community and/or central bank figures out how to deal with cash-hoarding, long-term inflation expectations stay low for awhile.
The Fed simply raising rates back to “normal” would just send the US economy back into a deflationary death spiral. In fact, such a move would result in lower rates in the longer term because rates will follow inflation expectations. If you want “normal”, you first need to get back to long-term nominal GDP growth above 4%.
What will stock markets do? As long as the Fed stays smart and doesn’t push its rates up too quickly, markets should do well. They’ll rest assured that the Fed won’t allow a massive collapse in aggregate demand like in 2008. And our long run of decent economic growth will continue. But if the Fed gets antsy, trying to pop asset bubbles that don’t exist, and raises rates too soon, then expect a very rocky road. Every time the Fed tries to pop an asset bubble (think 1929, 2008), markets do very poorly indeed.
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