The U.S. Interest Rate Prediction for 2017 Calls for a Financial Time Bomb
Fed Chair Janet Yellen took the markets by surprise. She clarified what pundits should make of the U.S. interest prediction for 2017. Yellen left so little doubt about the fact rates would be going up as stated last December that it must have taken the markets by surprise. On February 14, she used an uncharacteristic hawkish tone in her testimony to the Senate. (Source: “Fed Chair Yellen: ‘Unwise’ to wait too long to hike interest rate,” CNBC, February 14, 2017.)
What surprised the markets about Yellen’s U.S. interest rate prediction for 2017 was not the content itself, but the Fed’s determination. In a time when political leaders say one thing and then do another, that must have seemed like a shock. Indeed, The Fed chair did not deliver any surprises.
When Will the Interest Rates Rise?
The Fed chair could not have been clearer. She said that if the labor market continues to improve along with inflation, the rate hike would come as sure as the sun rises in the morning in the next few months. That said, considering the state of the Dow and Trump’s plans, it doesn’t take an economic genius to figure out that everything is moving in the rate hike direction now.
Postponing the rate hike any longer, said Yellen, would be “unwise.” That makes the intentions of the U.S. central bank’s policy about its planned “normalization” of monetary policy rather clear. Chances have doubtless risen that the Fed will adopt three hikes rates of 0.25% each.
The Fed’s goals, to manage the rising inflation, are even closer to materializing than two months ago, when Yellen announced the latest rate hike. Thus, nobody should be surprised if a rate hike came as early as next March; certainly by the time spring flowers decorate lawns in New England.
Rate hikes are coming; the fact that in the past three years Janet Yellen has raised them only twice—and by a minor amount—is the dead giveaway. The recent rate hikes have been so low, in fact, that it might be best to keep a cautious outlook. In the sense that the next set of rate increases will be deeper and occur with more frequency than expected.
Yellen will be looking to compensate for lost time. The economy is as close to full employment as it has been since the 2008 financial crisis. Unemployment is below five percent and inflation could start to catch up fast, potentially exceeding the targeted two-percent level.
The nominal interest, meanwhile, is so low that many Wall Street employees have never actually had to deal with anything above zero percent. The chart below needs little introduction and the interest rate forecast can only be bullish. The Fed rate has stood at zero since 2008.
The economic picture is such as to warrant unbridled enthusiasm. But before the bull is fully out of the gate, consider the risks. Trump may want to reduce the effects of globalization, which makes economies around the world function like a domino, but dismantling the system will need time.
That’s more than enough time for the storm winds to reach Wall Street from sick economic patients like the EU. Inflation in the eurozone is less than half of what it is in the U.S.—less than one percent. Meanwhile, the unemployment rate is close to 10%. The European Central Bank (ECB), meanwhile, has no intention of shifting its quantitative easing (QE) policies to a more restrictive monetary policy.
The ECB is fighting to keep the euro relevant in the face of the rising populist and anti-EU political parties. Thus, it has neither the reason or the will to become restrictive. And that would be clear enough if it weren’t for the fact that there are contradictions within the eurozone. In Germany, inflation is catching up fast to the two-percent goal that the ECB sees as ideal.
Thus, Germany would prefer to control inflation, seeing also as its unemployment rate of less than four percent puts it at the top of the EU. If it were up to Germany, in other words, the ECB would follow the U.S. example by ending QE and lift lending interest rates. If the ECB did so, it would virtually ensure the disintegration of the euro.
Why Are Interest Rates So Low?
If you see the chart above, from 1985 to 2008—2008 being the year of the last major global depression—real interest rates have dropped from about eight percent to four percent just before the Lehman Brothers collapse to two percent. But by December of that year, they went to virtually zero percent. The pattern was similar, even if the actual percentages vary, for the ECB, Why so low?
The Fed and the central banks of various countries—including the ECB—wanted to encourage growth after the financial collapse of 2008. In some cases, interest rates fell so low in the case of the ECB, the Bank of Japan, and a few other banks, that they ended up charging the various national banks for cash reserves through a de-facto negative interest rate.
But even more surprising is the fact that, in recent weeks, this practice has begun to spread among private companies: Sanofi, the French pharmaceutical company, and Germany’s sundries giant, Henkel, have issued euro-denominated bonds at negative yields. (Source: “Henkel and Sanofi set new milestone with negative yielding bonds,” The Financial Times, September 6, 2016.)
Low interest rates do have their advantages for a while. Countries that are highly indebted, like developing economies, appreciate the fact they can borrow at low rates. They also benefit from greater purchasing power, given their currencies are stronger vis-à-vis the international standard dollar and euro.
Investors may not share that view. But it’s easier to explain why the ECB and Fed got into the low-interest-rate situation than how to get out. Indeed, Yellen’s rate hikes won’t come without problems. Getting out will have an impact on investors.
Some free market purists accuse the central banks—like the Fed—of having artificially kept the market alive. In other words, they say the Fed has manipulated the markets. Few see the low rates as having represented the right response to the market dynamics that emerged in the years following the crisis. However, the main idea was to make borrowing money cheaper.
This is great while it lasts. It’s dangerous when macroeconomic conditions demand a change of pace. The low interest rates have continued to fuel a consumer debt base economy at the expense of savings. The very incentive to save has weakened due to soft rates.
The low interest rates also failed to match the theory that suggested investors would take more risks, investing more in starting or expanding businesses, giving an extra boost to the economy to restart. But this did not happen—especially in Europe. One of the effects is that banks kept dropping rates to achieve that goal.
This has turned into an interest rate vicious circle from which only the Fed has decided—the jury is still debating on whether it has figured out—how to get out. The Fed’s test is now. Janet Yellen had indicated the interest rate forecast last December, predicting at least two increases in interest rates over the course of 2017.
Some Still Doubt the Prospect of Rising Interest Rates
Some still refuse to believe the Fed. Their interest rate prediction is predicated on Yellen bluffing about the hike. The determined and hawkish tone of Yellen’s testimony before the Senate has failed to impress. Thus, not everyone believes the hike is coming in March. Some say in June.
Those that expect the next hike to come late in 2017, if at all, are clearly not bullish on Trump’s economic plans. By that logic, the market’s bullish course since last November reflects the end of the uncertainty about the election.
But in fairness, the suspense of that election has only just begun. There are many questions about what Trump will do in foreign policy. The game changes by the day. Until last week, it seemed Trump would collaborate with President Vladimir Putin in Russia. Now, one Michael Flynn resignation as National Security Advisor later, the stakes could not be higher.
Trump has promised to boost the economy through a stimulus package based on policies such as lower taxes and infrastructure spending. This might be a strategy to distract investors to put aside their worries. Many Americans—and others—of Republican and Democratic inclination fear Trump’s nationalist from immigration to import duties and the effects of protectionism.
Trump has promised a tax plan that is, to use his own description, “phenomenal.” That would wake up anybody’s spirit, not just those of the big investment banks. But, few seem to be concerned about the risks of this financial “turbo” effect.
The banks can’t wait for Trump’s deregulation. The new president has made it clear he wants to repeal various constraints such as the Frank-Dodd. But, these tools are there to protect investors! Instead, the market seems to be cheering the return of the high stakes game and the interest rate forecast doesn’t bode well in this climate.
It’s true that the prospect of higher rates tends to reduce the appeal of T-bills. Their values decrease as rates rise, thus pushing investors to equities. This may explain the Dow going beyond 20,000. But the appetite for risk is limited to those markets that tend to benefit from an accelerating global economy and the return of inflation.
This is not the situation we have now. Wall Street appears to have thrown caution to the wind again in the now daily game of setting a new Dow record. Meanwhile, however, the rising inflation and the rising rates will add unwanted strength to the U.S. dollar. The White House will not be too pleased by that phenomenon.
Trump has taken to accusing China, Japan, and any other major exporting economy of manipulating their currencies to make their goods more competitive. Now, he will no longer have that excuse. The stronger dollar combined with the rising protectionism might prove to be an obstacle to Trump’s economic recovery plan.
The result might be an extended war between the White House and the Fed. The latter will try to keep the gargantuan appetite for risk that led to the subprime crisis. While Trump will try to fulfill his promise of “making America great again,” the immigration restrictions might have undesirable effects on GDP.