The US economy appears to be thriving, despite recent challenges, with the stock market remaining strong. Therefore, it is difficult to say that rising interest rates will have a substantial negative impact on the economy. Consequently, the probability of the Federal Reserve not cutting interest rates at all in 2024 has gradually increased, no longer an unimaginable scenario.
This issue has not only made Wall Street nervous but also unsettled the general public. However, what problems might arise if interest rates continue to rise for a longer period?
At the beginning of 2024, investors did not expect the Federal Reserve to maintain high interest rates for a long time. However, they are now facing this reality as inflation has proven to be more stubborn than expected, lingering around 3%, while the Fed’s target is 2%.
Recent speeches by Federal Reserve Chairman Jerome Powell and other policymakers have solidified the view that there will be no rate cuts in the coming months.
In fact, some analysts even believe that if inflation does not ease further, the Fed may raise rates once or twice more.
This leaves a big question: when will monetary policy loosen, and what impact will the Fed maintaining interest rates have on the financial markets and the broader economy?
Currently, it is the earnings season for major companies across the US, and Quincy Krosby, Chief Global Strategist at LPL Financial, believes clues can be gleaned from the financial reports of these companies. Companies will provide key details beyond sales and profits, including the impact of interest rates on yields and consumer behavior.
Krosby said, “If companies are found to need to cut costs, causing issues in the labor market, then high interest rates are a potential root cause problem.”
However, at present, despite the S&P 500 recently dropping by 5.5%, the financial markets have remained relatively stable amid rising interest rates. The S&P 500 has already risen by 6.93% year-to-date, 23% higher than its low point at the end of October 2023.
Looking back over the last few decades, it is evident that interest rate hikes are not directly linked to economic recessions. As long as it is a period of economic growth, high interest rates are generally seen as a positive.
In the current strong growth period, the Federal Reserve has virtually no precedent for cutting interest rates. It is expected that the annualized GDP growth rate in the first quarter of 2024 will reach 2.4%, marking the 7th consecutive quarter of growth exceeding 2%.
Preliminary data for the first-quarter GDP in the US will be released this Thursday.
On the contrary, the Fed has often been criticized for maintaining low interest rates for an extended period, which led to the dot-com bubble in the early 2000s and the subprime mortgage crisis in 2008, catalyzing two out of the three economic recessions in this century.
In fact, some views suggest that the effect of the Fed’s interest rate policy on the US economy has been exaggerated.
David Kelly, Chief Global Strategist at J.P. Morgan Asset Management, said, “I believe the positive impact of monetary policy on the economy is not as significant as the Fed perceives.”
Kelly pointed out that over the past 11 years, during the 2008 financial crisis and the COVID-19 pandemic, the Fed attempted to raise the inflation rate to 2% through monetary policy, mostly ending in failure. In the past year, as inflation rates fell, simultaneous tightening of monetary policy occurred, but Kelly doubts this is largely related to interest rate policy.
Some economists have also put forth similar views, suggesting that monetary policy primarily affects “demand.” During these 11 years, demand has remained strong, and external supply issues have been the main driving force behind the deceleration of inflation.
Kelly mentioned that interest rates can indeed influence financial markets, and these markets, in turn, can affect economic conditions.
“Excessively high or low interest rates distort financial markets. In the long run, this could weaken economic productivity and potentially lead to bubbles, thereby disrupting economic stability,” he said.
He added, “I do think that interest rates are currently too high for financial markets, and they should strive to return to normal levels – not low levels but normal levels – and remain there.”
Kelly suggested that this could mean cutting interest rates by three notches (one notch equivalent to 0.25%), bringing the federal funds rate down to the range of 3.75% to 4% in the next year or two. This is in close alignment with the Federal Open Market Committee’s (FOMC) projection in its dot plot last month, setting interest rates at 3.9% by the end of 2025.
Futures market prices imply that by December 2025, the Federal Reserve’s fund rate will reach 4.32%, indicating that interest rates will remain high.
While Kelly advocates for “gradually normalizing interest rate policy,” he does believe that the economy and markets can withstand higher interest rate levels in the long term.
In fact, he views the Fed’s projected 2.6% “neutral rate” as unrealistic, a perspective gaining increasing support on Wall Street.
For example, Goldman Sachs recently suggested the neutral rate could be as high as 3.5%. Cleveland Fed President Loretta Mester also indicated that the long-term neutral rate could be higher.
This has led the markets to expect the Fed to somewhat lower interest rates, but not returning to the ultra-low rates seen post the financial crisis.
In the long run, even considering the prolonged period of low rates from after the subprime crisis in 2008 to 2015, totaling seven years, the average benchmark rate for the Federal Reserve from 1954 to date stands at a high 4.6%.
However, interest rate policy cannot only consider the overall economy. Over the past few decades, there have been significant changes in the US’s public fiscal situation.
Since the outbreak of the pandemic in 2020, US national debt has skyrocketed, surging by nearly 50%. The federal government is projected to have a $2 trillion budget deficit in the 2024 fiscal year, with interest expenses due to rising rates surpassing $800 billion.
In 2023, the federal deficit accounted for 6.2% of GDP; in comparison, the EU mandates member countries to keep deficits below 3% of GDP.
Some experts warn that high interest rates could also influence consumers, ultimately circling back to harm the US economy.
Troy Ludtka, Senior US Economist at SMBC Nikko Securities, stated that significant fiscal stimulus has injected enough vitality into the economy, making the consequences of the Fed raising interest rates less apparent. However, should benchmark rates remain high, this situation may change shortly.
Ludtka said, “One reason we haven’t noticed monetary tightening is that the US government is implementing its most irresponsible fiscal policy in a generation.”
“In an economy at full employment, we have enormous deficits, which sustain the situation,” he said.
Even though sales figures have not decreased, higher interest rates have begun to impact consumers. Federal Reserve data shows that credit card delinquency rates rose to 3.1% at the end of 2023, the highest level in 12 years.
Ludtka suggested that higher interest rates could cause consumers to “cut back on spending,” ultimately leading to a “cliff effect,” where the Fed will eventually have to concede and reduce interest rates.
“Therefore, I don’t think they should cut rates in the near future. But at some point, there will have to be rate cuts because such high rates are simply crushing lower-income Americans,” he said, “and that constitutes a significant portion of the population.”
(This article references related reports from CNBC)