In late August of this year, Federal Reserve chair Janet Yellen began hinting that the Fed might raise interest rates some time in September. Speaking at the annual meeting of central bankers in Jackson Hole, Wyoming, Ms Yellen said that “in light of the continued solid performance of the labour market and our outlook for economic activity and inflation, I believe that the case for an increase in the federal funds rate has strengthened in recent months.”
While there was a stock market reaction to the announcement, it was fairly mild, with the S&P 500 falling by just 0.16%. Tellingly however, the bond market was much more severely hit, with yields on two-year US government bonds rising by 6.8%, and on 10-year US government bonds rising by 3.6%. This speaks to the way in which the easy money policy which the Fed has been pursuing since the last crash, has inflated a bubble in the value of government debt, particularly in the current low-rates climate, where it’s seen as one of the few safe ways to see a return on your savings. (For more about how central banks have been inflating a dangerous government debt bubble, see my recent article for the Mises Institute.)
So why might a Fed rates hike start the next crash? Essentially, the low interest rates, quantitative easing, and general “money-printing” which central banks have been pursuing since the last crash, has allowed investors to bid asset prices higher than they otherwise would have been, and governments to borrow at lower cost. As illustrated by the Austrian Business Cycle Theory, not only does the cheap cost of borrowing enabled by artificially low interest rates allow for the inflation of unsustainable asset bubbles, but it also encourages businesses to borrow money to invest in more risky projects. The problem with this is that it gives the illusion of profitability to projects which would not have appeared profitable if interest rates had been allowed to naturally reflect the state of real resources in the economy.
When a central bank, such as the Federal Reserve, forces interest rates lower than they otherwise would have been, it distorts the signals businesses have available to them, concerning the state of real resources the economy has at its disposal. An artificially low interest rate signals that the economy has more saved up resources than it actually does. This makes certain, long-term investments appear as though they’re going to be profitable, when actually there aren’t enough real resources in the economy to see them all through to completion. Eventually, in order to avoid hyperinflation, the central bank will have to cease its money printing and allow interest rates to rise again, at which point a whole host of these projects across the economy are suddenly revealed to have been unprofitable all along, with the resources invested in them having been wasted. Bankruptcies ensue, and the crash begins.
Furthermore, to illustrate the way in which central bank money printing has created a bubble in the stock market, I have stolen this graph from Lara-Murphy.com, which shows a clear correlation between the rate at which the Fed has been increasing the money supply, and the value of the S&P 500.
The graph shows quite a striking correlation. Whenever the Fed has stepped on the gas and ramped up its quantitative easing – such as can be seen here between late-2012 and late-2014 – the stock market has boomed with it, and whenever it has hung fire the stock market has stuttered, as can be seen on the graph in late-2011. The extraordinary thing about this is that throughout almost this entire time period, Fed interest rates were close to 0%. The fact that, even during a time when borrowing was forced to be so cheap, so much of the stock market growth still seems to have been nothing more than a result of inflation, hints at just how little the US economy really has recovered from the Great Recession, even to this day.
A taste of the calamity we have in store for when this bubble finally bursts, was provided in December of 2015, when the Fed raised interest rates for the first time since 2006. Even that interest hike of a mere 0.25%, caused a dramatic downturn in the stock market, as can be seen on the graph above, and widespread speculation in January of this year that we were about to plunge into another recession. The massive downturn caused by such a modest rates hike then, gives an insight into the enormous degree of malinvestment which must be lurking under the surface of the economy, a bubble teetering precariously on the edge of bursting, kept there by low interest rates alone. When the Fed finally does have to raise rates more, and this stock market bubble finally bursts, I suspect that the similar bubbles throughout the economy – government debt, house prices, auto-loans, etc – which will come crashing down with it.
Even the mere suggestion of another possible rates hike has already caused a wobble in the economic house of cards the Fed’s easy money has propped up. The S&P 500 fell by 2.45% on Friday, its biggest decline since the Brexit shock, whilst the Dow Jones Industrial Average fell by 2.13% and the Nasdaq fell by 2.54%. The fact that these key economic indicators were so bludgeoned by even the faintest hint of a rates rise, lays bare the unstable, low rates fuelled bubbles which have been the source of so much of their apparent recent “growth”, and which now appear close to bursting.
So will the rates hike and crash really arrive this September?
While Ms Yellen’s remarks did initially spark concerns that this could be the case, prediction markets have now quieted down somewhat about the possibility of a September rates hike. According to the CME Group fed funds futures, the likelihood of a rates rise in September has fallen to just 27%. The consensus at this point is that the Fed will wait until after this year’s election before contemplating any further action, with the likelihood that a Fed Funds Rate hike will be agreed upon at the Fed’s final meeting of the year placed at 46%.
However, as much as I suspect a crash will follow any rates hike they do pursue, this delay is actually not necessarily good news. The longer interest rates are held low, the more malinvestments will be made before the crash comes, and consequently the worse the crash will eventually be. With interest rates having been at extraordinary lows since the start of the Great Recession, there’s no way of completely avoiding the fact that such a long period of low rates means malinvestments have already been made, the bubble has already been inflated, and so the crash is inevitably coming. It’s not within our power at this point to avoid the next crash altogether, because the mistakes which will cause it have already been made. But an early rates hike would at least get the recession out of the way before the bubble could inflate any further.
Sadly though, high rates in 2016 are scarcely more popular at the Fed than they are at the Bank of England. The likelihood that policymakers will be bold enough to raise rates enough to give us the short, sharp shock needed to rid us of this bubble and get the inevitable recession out of the way quickly, are rather slim.