The Fed raised interest rates yesterday, as expected.
The Fed has become…well, in a way, predictable. And, this is by design.
You see, they don’t want to make an unexpected move and spook the markets.
For the second time this year, the Fed hiked the funds rate. This time by a quarter of a percentage, now in a 1.75%-2% range. The US interest rate is now higher than Australia’s, which is at 1.5%.
And, as the economy heats up, the Fed may be looking at two more hikes this year.
Inflation has been edging higher. The consumer price index (CPI) data shows that it rose to 2.8% in May year on year. This is a much faster pace than we’ve seen in the last six years.
This isn’t a shock, as we have seen oil prices increasing. The West Texas Intermediate has gone up over 40% since this time last year.
Core inflation — inflation excluding food and energy — was up 0.2%, hitting a 2.2% increase year on year.
Unemployment is at a low 3.8%. Unemployment may be low, but salaries have remained flat when inflation is taken into account.
As reported by Bloomberg:
‘A separate Labor Department report on Tuesday illustrated how higher prices are pinching wallets: average hourly wages, adjusted for inflation, were unchanged in May from a year earlier, even as nominal pay accelerated to a 2.7 percent annual gain from 2.6 percent in April. For production and nonsupervisory workers, real average hourly earnings fell 0.1 percent from a year earlier.’
All in all, The Fed Reserve Chairman said ‘the economy is doing very well.’
But not all is hunky-dory in the US economy.
As you can see in the graph below, the US Federal Reserve — to boost the economy — kept interest rates low for a long time after the 2008 crisis. It also pumped large amounts of money into the economy through quantitative easing (QE).
[Click to enlarge]
Now the Fed is trying to normalise the economy by increasing interest rates and reducing the size of their balance sheet. Their goal is to have some room to manoeuvre in the next recession.
What could happen when the Fed starts tightening?
Well, it could mean the opposite of what we have seen in the last eight years. That is, asset prices go down, and easy money stops flowing.
That´s why the Fed is planning to do this very slowly.
The Fed has been raising interest rates slowly, in 0.25% increments, to avoid scaring the markets.
But, we could see inflation pick up at a quicker pace, especially as the recent US tax cuts take effect…
…and, if the US trade spat continues, if the US starts importing less from low-wage countries and sets up tariffs, goods will become more expensive. This will bring up inflation, which would in turn increase interest rates.
Having such low interest rates, for this long, has also meant we have accumulated a lot of debt.
The US national debt is now at a record US$21 trillion. US debt has almost tripled in the last 20 years.
And, as Moody’s recently wrote, we are not getting much growth from this debt anymore (emphasis mine):
‘The U.S.’ ratio of private and public nonfinancial-sector debt has soared from 1968’s 131% to 2017’s 253% of 2017. Nevertheless, the 10-year average annualized growth of U.S. real GDP decelerated from the 4.9% of the span-ended 1968 to the 1.4% of the span-ended 2017. Over time, higher ratios of U.S. nonfinancial-sector debt to nominal GDP failed to prevent a deceleration by U.S. real GDP’s 10-year average annualized growth rate. Additional debt may have warded off hard times, but it apparently fell considerably short of lifting the underlying pace of business activity.
‘Just as the velocity of money (or the ratio of GDP to the M2 money supply) has slowed over time so has the velocity of debt (or the ratio of GDP to nonfinancial-sector debt). Today each dollar of nonfinancial-sector debt is accompanied by only $0.40 of GDP. By contrast, in 1968, each dollar of debt was joined by $0.76 of GDP. Each additional dollar of debt may now add considerably less to GDP than it did 50 years ago.’
In other words, we’re increasing our debt, but we’re not getting much growth from it. You can see the divergence in the graph below.
[Click to enlarge]
Too much debt can become a burden, especially at higher interest rates.
Yet it’s not just the US who has been lowering interest rates, and increasing their debt, to boost the economy. Most developed countries are in the same boat.
World debt, in the last 10 years, has increased by 64%, going from US$142 trillion to US$233 trillion. A US$91 trillion increase.
Debt has been driving the global economy in the post-recession years. We fought off a debt crisis with more debt. Yet we are now left with high — and less productive — debt levels, compounded by rising interest rates.
Now central banks are looking to unwind their balance sheets and increase interest rates in preparation for the next recession.
And that could put the last decade’s ‘recovery’ into doubt.
Editor, Markets & Money