Over the last 20 or more years interest rates have fallen, for reasons other than falling inflation, and as interest rates have fallen so has nominal growth in a great many developed economies, and so has inflation fallen further. On the other hand debt has risen and so have asset prices, quite remarkably so in fact. But through this period we have also had a succession of financial and economic crisis, with the risk mostly of a financial nature, and in response to these asset price risks, interest rates were either cut or held low for, in my opinion, far too long.
The Fed would now like to raise interest rates, and so too would other seemingly “well on the way to economic recovery nations”. The trouble is the “economy and our markets” are now more than ever sensitive to changes in interest rates. The Fed partly knows this, is partly concerned that interest rates lie at close to zero (and unless they want to go negative, a place they probably worry they may never climb out of) would like to see them a bit higher, to allow them to cut interest rates in a subsequent crisis.
In the last cycle the the Fed Funds rate rose to 5.25 and currently loiters around the 0.11 to 0.12 range. I would suspect that a Federal Funds rate of 4% was too high for the last upward cycle and would also posit that rates would be hard pressed to rise above 2% in the current cycle before we saw the type of wrenching market reaction…but this all assumes everything else being equal. Markets are too well worn around the interest rate, money supply asset price equation to lay back and wait for the interest rate cycle to hit economic growth. The question is though how much of an asset price shock can the “economy take as interest rates rise before that asset price shocks impacts the economy? I guess that is the question and the Fed is trying to work out just how sensitive the world is to a rise in interest rates. It just does not know and while the risk of rising rates may be extremely high it may well have figured that “the Fed’s got to do, what the Fed has got to do…”.
As many other commentators have pointed out, a whole panoply of other risks have started to move out of the closet (namely the many risks posed by a sharply appreciating US dollar), risks that may already constrain the Fed from acting.
Current rates on 5 year treasuries are around 1.5% and stood at some 4% in early 2007. I would have thought that the peak rate for the Fed rate would be around this level at the current juncture, but just how to get through to it is the question?
The Interest rate, debt and asset value chokehold
More thoughts on the frame & the risks