A couple of days back, the FED decided to delay the increasing of the interest rates once more, which again brought a momentary respite for markets. Well, who doesn’t like near zero interest rates? However, have we considered the implications of such a long period of low interest rates? The spenders are the ones benefitting from such a policy compared to the savers.
Hence, I thought I share some of my thoughts regarding this issue. Feel free to correct me if you disagree with any points I raised, afterall, I am no Economist despite having majored in Economics.
Point 1: Stop supporting markets
I get the feeling that the FED seems to be accommodating investors than the other way around. The FED’s mandate is to ‘promote sustainable growth, high levels of employment, stability of prices to help preserve the purchasing power of the dollar and moderate long-term interest rates.‘ In layman terms, they should prevent risky asset markets from forming, where valuations starts running ahead of fundamentals, such as what we saw during the Global Financial Crisis.
While I would not say that markets are at a point that is risky, however, markets are much stronger and have largely recovered compared to the period after the Global Financial Crisis. The state of the economy now should have reached a level where it is able to withstand higher interest rates.
Why do I say that markets are able to withstand the higher interest rates? Essentially, it is based on the following 2 points, I extracted from the September 2015 FOMC Statement.
- The labor market continued to improve, with solid job gains and declining unemployment. On balance, labor market indicators show that underutilisation of labor resources has diminished since early this year.
- Inflation has continued to run below the Committee’s longer-run objective, partly reflecting declines in energy prices and in prices of non-energy imports. Market-based measures of inflation compensation moved lower; surgery-based measures of longer-term inflation expectations have remained stable.
Are these not indications of a strengthening economy? Everyone loves near zero interest rates, as this means cheap money. However, to put it crudely, it allows the weak to survive, defying the law of nature. What do I mean by this? With such cheap interest rates, it allows companies to increase their debt to sustain their aggressive growth ventures, punishing companies that operates more prudently or conservatively. Often, it is these former type of companies that is recognised by the market as aggressive companies are seen as growth companies. For us to see the latter type of companies to be recognised by the market, we need interest rates to increase to force out some of the weaker companies that have been constantly increasing their debt levels.
Point 2: Markets need a clear indicator
The hype created before FOMC meeting causes large uncertainty within the markets. Hence, by increasing interest rates, it sets the tone and gives market a clear indication of what to expect. This is much better than allow investors to constantly speculate when interest rates are going to be raised.
Such as about a week back, investors reacted positively to Yellen’s comments on increasing the interest rates by the end of this year. However, a few days later, the news was reporting on how investors are starting to second guess if Yellen was speaking the truth.
