The global economy has gone through a rocky road in the recent month (and actually, still continues to go through) with the People’s Bank of China (PBOC) allowing its currency to go through a one-day depreciation of two percent, the poor second quarter Gross Domestic Product (GDP) growth recorded by Japan, the barely-breathing and debt-shattered Greek economy, the fluctuations and heightened volatility in the stock markets worldwide led by those in the Asian region, the weakening commodity prices and the United States Federal Reserve’s rate-hike outlook. Not surprising, these are just some of our growing economic concerns.
Consequently, on Thursday, Fed policymakers are set to conduct a two-day monetary policy meeting, which investors and analysts alike have long been waiting for, given the bothersome condition of the world’s financial sectors. The final decision regarding the central bank’s September rate-hike prospects will primarily be tackled. For weeks, the Fed and its officials have expressed uncertainty of a rate hike and its timely implementation, stating that the decision will be highly “data-dependent”. Finally and hopefully, our questions will be given the paramount answers.
We cannot blame the Fed officials for their persistent confusion. The decision is not necessarily binary. It does not only involve a simple question of whether to do or not do. Typically, before every policy meeting, the central bank’s economists cite to the officials a handful of choices that include middle-ground options that vary between Fed “hawks” who disregard low interest-rate policies and Fed “doves” who back easy money.
The Fed has not increased interest rates in almost a decade and some concerned experts still think that it is not yet time for the central bank to carry out a (much-needed) rate hike. They believe that the economy is way too hurt to afford an increase in the interest rates of the world’s top central bank. As Harvard professor and former Obama administration economic adviser Larry Summers says, a rate hike is “tipping some parts of the financial system into crisis.” Summers emphasizes -- as a strong basis -- the incident in 1994 when the Fed suddenly imposed a 0.25 percent increase in interest rates, which was later followed by what Fortune Magazine called “Bond Market Massacre”. On that note, the bond market today has expressed its distress over the possible increase in rates. Doubleline Capital Founder and Bond King Jeffrey Gundlach noted the many reasons the Fed should not pursue an interest-rate hike -- the weakening of the world’s second largest economy, the decline in commodity prices and the sparse inflation rate to name a few -- saying, “Dammit Janet (referring to Fed Chairwoman Janet Yellen), do not raise rates.”
The previous monetary policies had us acquainted with slow rises in interest rates. Most of us believe that high interest rates will hurt the economy as it will limit government borrowings. How did this happen? How did gradual interest rate increments become so unbearable for the economy? Since when did a rate hike of a quarter of a percent become too much to deal with?
Greenspan And Bernanke
Alan Greenspan, the 13th and newly confirmed Fed Chairman during the 1987 stock-market crash (commonly termed as “Black Monday”), lowered interest rates to one percent shortly after the tremendous drop in worldwide shares and the tech bubble. Being the monetarist that he is, Greenspan had a diverse view on the economy. His monetary policy decisions were -- accordingly -- largely patterned after the Taylor Principle, a monetary policy rule imposing how much the central bank must change the nominal interest rate in response to inflation, output and other economic indicators. His monetary-policy approach is commonly known as the “Greenspan put”.
After the mild recession, the Fed tightened monetary policy with an increment of a quarter of a percent at a time to avoid agitating the financial institutions.
It turns out that Greenspan and his successor Ben Bernanke did not also see the subprime housing debt mayhem coming their way. Predatory lenders imposed excessive interest rates, leading a number of people into undesired foreclosures. We all thought that real estate was a very disparate asset to ever encounter a market bubble and we were proven wrong. Tightening monetary policy and lending might not have fully controlled the bubble from occurring but they could have kept it from worsening.
We have had reasonable warnings since 2005 but the central bank and the Treasury were still bushwhacked by the crash of leading American companies Lehman Brothers Holdings, Inc., Bear Stearns Companies, Inc. and American International Group, Inc. (NYSE:AIG) in 2008. Along with the collapse in the mortgage markets, these three companies shed billions of dollars, greatly contributing to the Global Financial Crisis. Exactly seven years ago, financial services firm Lehman Brothers filed for the largest bankruptcy in American history. With the liquidity problems encountered by the Lehman Brothers, the Dow Jones Industrial Average experienced its biggest one-day loss since the September, 2001 attacks, tumbling 4.40 percent. Meanwhile, global investment bank and securities trading and brokerage firm Bear Stearns was eventually sold to multinational banking and financial services holding company JPMorgan Chase & Co (NYSE:JPM) while multinational insurance company AIG sought financial assistance through government bailouts. Needless to say, this paved way for the darkest days in the ever-progressive Wall Street. As a result, Bernanke introduced three rounds of quantitative easing, adding about $3.50 trillion in purchases to the central bank’s balance sheet. Due to the market collapse, the emergency zero percent overnight lending rate was unexpectedly deemed necessary. The next thing we know, seven years later, we still regard its necessity.
The Market Bubbles
Robert Shiller, the economist who forsaw the coming of the tech and real estate bubbles in the recent decade, said earlier this year that the Land of Liberty is potentially headed for a bond-market bubble. At the same time, high-end housing and art markets seem to be reaching the same zone. However, a serious correction in the US equity market is most likely to happen and prevent the economy from hitting the bubbly territory.
The bubbles are triggered by the hundred billion dollar debt in the energy sector, particularly in the fracking business. Oil prices may have a doubled value today but most borrowing companies were not cash-flow positive. The oil industry have promptly recouped following the 2008 Global Financial Crisis but the current trend of production oversupply makes the situation more comparable to the 1980s, a turmoil that saw a long-term correction since companies kept on producing more crude as a result of desperate measures.
Concerns Over The US Economy
With a number of positive indicators since the year began, it is evident that US equity markets have significantly been overvalued. However, the surfacing of various concerns for the American economy is quite inevitable.
At the expense of long-term capital investment, American companies have disclosed that dividends and share buybacks for 2015 amount to more than $1 trillion -- pretty far greater than their estimated profits combined. American corporations nowadays care more about share prices than long-term growth prospects.
Another worry is the growing number of private-market investments. Private firms find it relatively easy to raise capital, triggering market bubbles. As American businessman Mark Cuban puts it, “The bubble of today comes from private investors who are investing in apps and small tech companies.” (Cuban sold his online television website Broadcast.com at the peak of the internet era in 1999 to Yahoo (NASDAQ:YHOO), Inc. for $5.70 billion, a deal that the multinational technology company eventually regretted sealing)
For example, California-based international transportation network company Uber Technologies, Inc., an emerging industry whose shares are not yet profitable -- and nonetheless growing, got two new rounds of such funding. In just a year, the valuation of the company easily jumped from $20 billion to $50 billion.
Ironing It Away With Normalization
The proper -- and probably only -- way to respond to these growing concerns is a rate hike. The central bank has to take the hint. If the Fed is to normalize interest rates, the time is now. There is no reason to prolong the agony since whatever the circumstances are, it will transpire anyway. Stocks are still up by 200 percent from the preceding bottom. It is then safe to say that the economy is strong enough to withstand such correction. In the grand scheme of things, a mild recession is already something that our financial systems can deal with. It is nothing compared to the economy boost that comes together with it.
For so many years, now, fixed-income investors have drowned themselves in irresponsible lending that yields too little returns. As a result, instead of generating more money, we only accumulate unceasing losses. We cannot deal with further debt problems by subsidizing more -- let us take that from the financial dilemmas experienced in prominent economies like Europe, Japan and China.
The equity markets have been lacking a sense of responsibility because investors have complacently relied on bailout funds. Markdowns may seem painful but they can help correct the irresponsibility that has been lingering for quite long. We need to get back on track.
The Taylor Rule suggests that an increase in inflation rate is equivalent to an increase in nominal interest rate. If only we truly followed the Taylor Rule, the central bank would have lifted overnight rates back up to the range of 2.50 percent. Annually, we could have had spawned $1 trillion and had allowed the US GDP to gain 6 percent.
Our worries over the worsening trade problems are honestly illogical because a 2 percent differential is not that relevant to currency variations. Without changing the overnight lending rates, exchanges between the dollar and the euro have varied 10 to 20 percent annually anyway. Also, the average American would not likely be hurt as credit card interest rates are still at a 13 percent average and mortgage rates would barely rise.
After all that has been said and done in the past decade, you may ask now, “What does this tell us?” Well, this is a call for us to put an end to Greenspan put and Bernanke’s quantitative easing. We need to go back to the basics in order to pop and combat the forthcoming market bubbles. The present Fed and its policymakers need to take its undertakings more seriously with its own strategic measures. Undeniably and evidently, a rate hike has a really great impact on the markets. However, it is always better to take a minor setback for a major comeback. The odds are, in any way, in the favor of progress. The Fed must implement a 0.25 percent rate hike this month, followed by 0.50 percent increase shortly after. Of course, we cannot opt for abrupt increments as this will shake the economic stability, especially now that we are barely sustaining it. With the troubled global economy we have today, we can only go for gradual changes that will take eventual effects. After all, the only enemy of success is stagnation.
Despite the looming of varying opinions, I believe that the Fed’s rate hike will greatly help regain confidence in the whole economy. I don’t know about those who are against it, but I think that we are more than ready for the central bank’s move to normalize interest rates and loosen our grips; we just find it difficult to see as the pressing economic problems keep on overshadowing. It has long been due and the time is now.