In commenting about their long-anticipated decision to raise interest rates, Fed officials said they intended to raise interest rates “gradually”. They predicted that rates would rise about 1% per year for the next three years. But they also said they would raise interest rates “only if economic growth continues.” That’s important, because for the last few years the Fed had warned it would be raising rates once there was “economic stability”, “full employment” or once inflation had increased enough (concerned that inflation was supposedly below 2%, their target). Even though the last recession was said to have ended in 2009, over the last six years, the Federal Reserve has repeatedly come up with excuses as to why they cannot raise interest rates, even from extremely low levels.
As a result, interest rates have been unchanged for more than 7 years, a record amount of time in which rates were not allowed to rise, and at record-low levels. Even during the fallout of the dot-com bubble in the early 2000s, the Fed only allowed the Fed Funds rate to fall to 1%, by late 2003. Just as importantly, the Fed did not allow interest rates to stay at such low levels for an indefinite period of time. It was just twelve months after interest rates reached their nadir in mid-2003, that the Fed began raising interest rates.
In addition, back in 2004, when the Fed did start raising interest rates, it did so steadily, not pausing to reflect on whether economic growth, inflation or employment was at the perfect level. They knew that rates were artificially low and artificially distorting the economy and despite the uncomfortable transition, higher interest rates were required to begin to normalize the economy. As a result, beginning in July 2004, the Fed steadily increased the Fed Funds Rate from 1% to 3% in the twelve months from June of 2004 to mid-2005, continuing to increase it to 5% by mid-2006. The Federal Reserve then kept the rate at 5.25% until the financial crisis of 2007-8. At that point, the Fed began lowering interest rates once again until its Fed Funds rate was about 0% by the end of 2008. It has remained near 0% since.
We can contrast the Fed’s relative discipline back in 2003-6, in which it allowed interest rates to stay at 1% for just one year and steadily increased interest rates 4% over a period of just 2 years, with the Federal Reserve today. Today’s Fed not only allowed near-0% interest rates for more than 7 years, they also say that not that they’ve finally begun raising rates, it might raise rates 1% per year over the next 3 years. And that’s if the economy does exactly what the Fed wants it to.
Looking back at that graph of the Fed Funds Rate, we see that in the last 60 years, until this most recent period, the Federal Reserve had never let such a long period -9 years – elapse without raising interest rates. (Until this month, the last Fed Funds increase – from 5.0% to 5.25% - was in July 2006.) In the past, regardless of wars, stock market crashes and recessions, it was rare that even a few years would pass before the Federal Reserve would become concerned about inflation or economic distortions resulting from artificially low interest rates. And those earlier times were with interest rates much higher than the last several years.
The fact that interest rates have needed to be kept from rising for so long and held at such economy-distorting low levels tells me that overall, this is structurally the weakest economy that has existed in the last 60 years. I wrote recently about the importance to the Fed and governments of having an elevated stock market to support the economy. In the current environment the stock market is not reflecting the fundamentals of the economy so much as the economy is supported by the stock market itself. Perhaps the primary motivation of the Federal Reserve to keep interest rates at such extremely low levels, thereby artificially boosting the stock market, bond market and real estate market. If it can do that, although the economy will be distorted, enough money will flow through it to avoid a general depression.
Historically, interest rates would decline during periods of economic weakness or crisis. The difference between past times and now, is that in the past the economy would recover relatively quickly enough so that interest rates would begin rising again. This interest rate rise would “normalize” the period of lower interest rates and economic weakness. But this is not the case now, when it has been over 8 years since interest rates began their fall, with the recent token 0.25% increase erasing less than a twentieth of the decline from more normal and healthy interest rates.
Over the past 60 years the average Fed Funds Rate was 5.0% (even including the last 7 years of nearly 0% rates). Right now the rate is at 0.37%, less than a tenth of its normal level. Even if the Fed does as it says and raises rates by 1% a year for the next three years, 2019, the Fed Funds Rate will still only be around 3.5%, far below its historical average. By that time it will have been more than a decade since interest rates were last at normal levels. We can only imagine the economic distortions that such low interest rate have already caused to this economy, and the world’s, and the remaining distortions that will come from the next few years, perhaps decades, of artificially-low rates.
The recent increase in the Fed Funds Rate changes almost nothing. It’s too little and too late. In fact, it guarantees more of the same. The Federal Reserve will never raise interest rates to a normalized level again. It can’t. There’s too much debt, too much of the economy and financial assets leveraged to a world of ultra-low interest rates, too little in the way of economic fundamentals and too many individuals, businesses and governments addicted to and dependent upon cheap money.
U.S. Follows Japan
We already have a good example of a population that has taken the path that the U.S. is now following - Japan. Japan has already walked the path of near-0% interest rates for more than two decades with miserable economic results to show for it.
From the mid-1950s until 1990, Japan led the world in its contributions to the growth of the world’s economy. From 1955 to 1970 Japan grew at more than 8% per year (data from IMF and United Nations). During the 1970s when much of the world was mired in stagflation, Japan continued to grow at more than 4% per year and continued such strong growth in the 1980s. Their interest rates reflected that growth, generally around 5% during the 1980s. Unfortunately, asset bubbles and overinvestment (even at 5% interest rates!) resulted in their economic crash in 1990.
In response, the Japanese government quickly lowered their interest rates, steadily lowering them from 6% in 1990 to 0.5% by 1995. What has followed has been year after year of interest rates below 1% in a misguided attempt to “revive” their economy. Instead what they have had is 20 years of uneven and middling growth, all on the back of very “accommodating” interest rates. According to data from the World Bank, Japan’s yearly average economic growth averaged 0.8% per year during the period of 2000-2014, far below world averages.
Low interest rates have not solved Japan’s economic problems as basic economic fundamentals and thinking economists would not predict. Ironically, in the 1990s, U.S. Congressmen and Federal Reserve officials lectured Japan on the economic dangers of having such low interest rates and for keeping them so low and for so long. This makes it clear that the government often does know the right thing to do, but is unwilling to do it.
So in the end, and despite knowing better, the U.S. will follow in the footsteps of Japan. Instead of fixing their underlying problems in the economy, and with government programs and spending, it will do the easy thing. It will continue to artificially restrict interest rates, levitate the financial markets and flood the economy with money. Because the reality is, that that “strategy” can work – in the short-term. It worked for a few years after the dot-com crash as low interest rates fueled the housing bubble and levitated the economy for several more years after the crash. And it seems to have worked in recent years with financial markets at record highs, low unemployment rates, and a growing economy (though also accompanied with ballooning debt).
But low interest rates do not solve fundamental economic problems - they only obscure them. As Japan learned in the 1990s and the U.S. in the 2000s, once bubbles are busted, artificially lowering interest rates to generate other bubbles is not a long-term strategy. It only guarantees more economic volatility, future bubble-busting and overall, weak economic growth. Keeping interest rates so low and for so long, instead of making fundamental changes to its financial and economic system only insures that the future experience for the U.S. will be similar to Japan’s. Like Japan, the U.S. will maintain a structurally weak economy in which raising interest rates in any meaningfully significant way will not be possible because of what it will expose under the surface.
If interest rates ever were allowed to rise in a meaningful way, there would be serious consequences. Fewer people will take out loans, consumer spending would decline, unemployment would rise, governments and businesses would have a difficult time issuing debt and governments would have to be much more concerned about the levels of their deficits and debts. As a result, increasing interest rates to normal levels will not happen.
Money is the lifeblood of an economy. You cannot distort the cost of money for a decade and expect there to not be serious consequences. We have all heard the saying that there’s no such thing as a free lunch. It’s the same thing with money. There is no such thing as (nearly) free money. There is a cost to money and a bigger, hidden cost from cheap money. Interest rates artificially set below the market enact a huge cost onto the economy, even if it’s hidden from many for a period of time.
In the past, the marketplace set those interest rates. A person, government or business which was deemed a riskier debtor was given a higher interest rate. Responsible borrowers were given lower rates. But we now live in a world in which governments (or quasi-government agencies like the Fed or other central banks) decide the interest rate that people will pay (including for their own government debt) and regardless of whether those borrowers deserve to borrow at such low rates. This distorts the marketplace, the economy, governments and even society.
The future is impossible to know. A distorted world is even more difficult to predict, but we can see from example and logic that such contortions will lead to more in the future.