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Why the Fed Keeping Rates Higher Longer May Not Be Such a Bad Thing

Why the Fed Keeping Rates Higher Longer May Not Be Such a Bad Thing


U.S. Federal Reserve Chairman Jerome Powell arrives to testify during a House Financial Services Committee hearing on the “Federal Reserve's Semi-Annual Monetary Policy Report” on Capitol Hill in Washington , DC, March 6, 2024.

Mandel Ngan | Afp | Getty Images

While the economy is doing well and the stock market, despite some recent ups and downs, is holding on quite well, it is difficult to convince that rising interest rates are having a significantly negative impact on the economy.

What if policymakers simply decided to keep rates where they are for even longer and go through 2024 without cutting them?

It's a question that, despite current conditions, makes Wall Street shudder and Main Street nauseated as well.

“When rates start to rise, there has to be an adjustment,” said Quincy Krosby, chief global strategist at LPL Financial. “The calculus has changed. So the question is: Are we going to have problems if rates stay high for longer?”

The policy of maintaining a high rate for the long term was not what investors expected at the start of 2024, but it is what they must face now, as inflation has revealed itself more stubborn than expected, hovering around 3% compared to the Federal Reserve's 2% target.

Recent statements from Fed Chairman Jerome Powell and other policymakers have reinforced the view that rate cuts will not come in the coming months. In fact, there has even been talk of the possibility of one or two more increases to come if inflation does not slow further.

This leaves big questions about exactly when monetary policy easing will occur and what the consequences of maintaining central bank monetary policy will be on financial markets and the economy as a whole.

Krosby said some of those answers will come soon as the current earnings season heats up. Company executives will provide key details beyond sales and profits, including the impact of interest rates on profit margins and consumer behavior.

“If there's a sense that businesses need to start cutting costs and that leads to problems in the labor market, that's where there's a potential problem with rates this high,” said Krosby.

But financial markets, despite a recent 5.5% decline in the S&P 500, have largely held up amid higher interest rates. The general large-cap market index is still up 6.3% since the start of the year against a status quo Fed, and 23% above the low at the end of October 2023.

Higher rates can be a good sign

History tells different stories about the consequences of a hawkish Fed, both for markets and the economy.

Higher interest rates are generally a good thing as long as they are associated with growth. The last period where this was not true was when then-Fed Chairman Paul Volcker throttled inflation with aggressive hikes that ultimately and deliberately tipped the economy into recession.

There is little precedent for the Fed to cut rates in periods of robust growth like the current one, with gross domestic product expected to accelerate to an annualized rate of 2.4% in the first quarter of 2024, which would mark the seventh consecutive quarter growth better than 2%. Preliminary first quarter GDP figures are due to be released on Thursday.

In the 20th century, at least, it is difficult to argue that high interest rates led to recessions.

On the contrary, Fed chairs have often been criticized for keeping rates too low for too long, leading to the dot-com bubble and subprime market implosion that triggered two of this century's three recessions. . In the other case, the Fed's benchmark funds rate was only 1% when the Covid-induced slowdown occurred.

In fact, some argue that there is too much emphasis on Fed policy and its broader impact on the $27.4 trillion U.S. economy.

“I don't think active monetary policy actually moves the economy as much as the Federal Reserve thinks it does,” said David Kelly, chief global strategist at JP Morgan Asset Management.

Kelly points out that the Fed, in the 11 years between the financial crisis and the Covid pandemic, tried to bring inflation down to 2% using monetary policy and essentially failed. Over the past year, falling inflation has coincided with a tightening of monetary policy, but Kelly doubts the Fed had much to do with it.

Anything that makes the Fed look stupid hurts its ability to maintain price stability (Jim Cramer)

Other economists have made a similar argument, namely that the main issue that monetary policy influences demand has remained strong, while the issue of supply, which operates largely outside the scope of monetary rates Interest was the main driver of the deceleration of inflation.

Where rates matter, Kelly said, is in financial markets, which can in turn affect economic conditions.

“Rates that are too high or too low distort financial markets. This ultimately undermines the productive capacity of the economy in the long term and can lead to bubbles, which destabilize the economy,” he said .

“It’s not that I think they set rates at a bad level for the economy,” he added. “I think the rates are too high for the financial markets, and they should try to get back to normal levels, not low levels, but normal levels and keep them there.”

The likely path will be higher and longer

Public spending problems

However, one thing that has changed dramatically over the decades is the state of public finances.

The national debt of $34.6 trillion has exploded since the arrival of Covid in March 2020, increasing by almost 50%. The federal government is on track to run a $2 trillion budget deficit in fiscal year 2024, and net interest payments, thanks to these higher interest rates, are on track to exceed 800 billion dollars.

The deficit as a share of GDP in 2023 was 6.2%; in comparison, the European Union grants its members just 3%.

Ruchir Sharma on 'overstimulated' US economy: We saw the same scenario in China

Fiscal largesse has boosted the economy enough to make the Fed's higher rates less noticeable, a situation that could change in the coming days if benchmark rates remain high, said Troy Ludtka, U.S. economist. senior at SMBC Nikko Securities America.

“One of the reasons we haven't noticed this monetary tightening is simply a reflection of the fact that the U.S. government is pursuing its most irresponsible fiscal policy in a generation,” Ludtka said. “We're running massive deficits in a full-employment economy, and that's really keeping things afloat.”

However, rising rates have started to take a toll on consumers, even as sales remain strong.

Credit card delinquency rates climbed to 3.1% at the end of 2023, the highest level in 12 years, according to Fed data. Ludtka said raising rates would likely lead to a “pullback” for consumers and, ultimately, a “cliff effect” in which the Fed would ultimately have to give in and lower rates.

“So I don't think they should be cutting interest rates in the immediate future. But at some point it's going to have to happen, because these interest rates are just crushing low-income Americans,” he said. he declared. “That represents a large portion of the population.”

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