Can the federal reserve rate hike rates meaningfully

The growth rate of the United States has been below trend since the 2008 recession with the last quarter GDP growth estimate at 1.2%1. The American economy since the trough of 2009 has been driven by three forces namely fracking funded by large debt, technology sector funded by high valuation and housing recovery funded by low mortgage rates. Low oil prices are already putting pressure on the fracking industry despite significant cost reductions. Residential investment accounted for 3.8% of GDP as of Q2 2016 below its long run average of 4.56%2. Low yields on treasuries led the investors to look to other places for returns. A lot of this money found its way to the technology sector which has led to increase in the number of ‘unicorns’ (startup valued over $1bn) which are around 1003. These companies have not operated in an environment where borrowing costs fluctuates with upward bias. Whenever a lot of capital flows into a sector there are bound to be malinvestments. A rate increase may lead to failed investments and also perverse feedback loops once some companies fail where even good companies might get hit.

Another interesting point to note is that, contrary to the general theme that innovation will boost growth rate, the larger contributor to growth rate has been increase in capital inputs. Growth accounting reveals that over the period 1989-2014 contribution to growth in America was due to capital investment (51.2%), labor (25%) and total factor productivity (23.9%)4. Since population growth rate is now at low rate of 0.73% for 2016, increase in labor is not going to be a contributor of growth as it was in the past.

As the global economic growth is lackluster, and the dollar continues to strengthen the external sector can’t be relied upon for growth. With lack in growth of labor inputs and a low historical annual increase in total factor productivity of 0.6% it is growth in capital inputs which will drive growth. Growth in capital inputs which has accounted for 1.2% GDP growth a year is going to be the pillar of economic growth for years to come.

A rate hike will decrease capital investment which is already below trend. If the fed raises rates demand for mortgages will fall, and at the same time excess money in the stock market starved of fixed returns will rush to safety in treasuries. The dollar strength will also increase due to capital inflows from foreign countries into US treasuries. The velocity of M2 has been on a downward trend and is 1.448 for Q2 of 2016, indicating the economy is yet to recover as per this measure5. Although Unemployment rate is at 4.9% the labor force participation rate is at 62.8% indicating chronic underutilization of resources6. All these facts add up to reinforce that an economic recovery is still elusive.

Chart 1: Monetary base vs S&P 500 (Jan 1996 - June 2016)7

Another trend that we observe is that before the 2008 crisis the correlation between monetary base and S&P 500 levels was 0.52 after the federal reserve started expanding its balance sheet the correlation has jumped to 0.9. It essentially implies that the stock market is being driven by money pumped in by the federal reserve. It is possible that the federal reserve aims to boost the economy by the wealth effect, but the required structural changes to boost potential GDP has not been made.

Given the above factors, if the federal reserve hike rates now or in the foreseeable future without improvement in potential GDP it will lead to an increased probability of fat tail events.


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