Why The Fed Should Raise Rates Now

By Brad Brooks at Bloomberg

Now that U.S. stock markets have experienced their first 10 percent correction since 2011, investors are again looking to the Federal Reserve to bail them out. Although the Fed hasn't raised interest rates in almost 10 years, sympathetic pundits say it's still too soon to raise them now. The economist Larry Summers, runner-up for the top spot at the Fed a few years ago, says raising rates would risk "tipping some parts of the financial system into crisis."

How did our financial system weaken to the point where a quarter of a percent increase in rates is more than it can handle?

The process started a dozen years ago, when Alan Greenspan -- then chairman of the Fed -- decided to lower rates to 1 percent after the country had emerged from the mild recession that followed the popping of the tech bubble. Then, when the Fed began to tighten policy, it did so with agonizing slowness -- raising rates just a quarter of a percent at a time, so as not to upset the financial markets.

This set the table for the subprime housing debt mess in a way that neither Greenspan nor his successor, Ben Bernanke, could foresee. Everyone assumed real estate was too diverse an asset class to ever be in a bubble. Despite credible warnings about the potential problems starting in 2005, the Fed and Treasury were still blindsided in 2008 by the enormous losses at Bear Stearns, Lehman and AIG. Suddenly, the emergency 0 percent overnight lending rate was required and, almost seven years later, it's still deemed necessary. Meanwhile, three rounds of quantitative easing have added roughly $3.5 trillion in purchases to the Fed's balance sheet.

What we have to show for this is a more concentrated financial system, in which the top five banks control nearly half of all U.S. financial assets. Even more troubling is evidence that, this time around, asset bubbles have formed in multiple arenas. Earlier this year, the economist Robert Shiller, who predicted the tech and real estate bubbles, warned that the U.S. now faces a potential bubble in the bond market. The high-end housing and art markets also seem to be in bubbly territory, but before they can cause too much trouble we're likely to see a serious correction in the U.S. equity market.

The trigger is likely to be the hundreds of billions of dollars worth of bad debt in the energy sector -- loans that were made to finance the fracking frenzy. Even when the price of oil was twice what it is today, many of the borrowers involved were not cash-flow positive, and few adequately hedged their exposure. While the experts like to talk about how quickly the price of oil rebounded after the financial crisis, the current oversupply makes today's situation more akin to what happened in the 1980s. That took years to correct, as desperate companies and governments kept producing more crude.

Whatever the catalyst, a handful of indicators suggest that since the beginning of this year, the U.S. equity market has been significantly overvalued. The ratio of gross domestic product to market cap, as well as Shiller's CAPE ratio (stock price divided by 10-year average of earnings divided by inflation), demonstrate that the market has been stretched to extremes not seen since 2007. The amount of margin interest being used is at a record high, as is merger and acquisition activity. Earlier this summer, PEG ratios (price to earnings growth expectations) by analysts of the companies in the Standard & Poor's 500 were at 1.7 -- the highest in 20 years, and 30 percent higher than average.

Perhaps the most disturbing statistic is that American corporations have announced dividends and share buybacks for this year that total more than a trillion dollars -- more than all their projected profits combined. This is happening at the expense of long-term capital investment, as corporations seem to care more about share prices -- upon which so much executive compensation is based -- than about prospects for long-term growth.

Another area for concern is the burgeoning private market for investments, where companies are finding it relatively easy to raise capital. Uber, for example, a not-yet-profitable car-service company, got two new rounds of such funding -- and saw its valuation jump to $50 billion, from $20 billion, in a little more than a year. As billionaire Mark Cuban, who sold his company Broadcast.com at the peak of Internet mania, said, "The bubble today comes from private investors who are investing in apps and small tech companies."

This is why the Fed has to finally take away the punch bowl. The economy may not be in top shape, but it's strong enough to handle an equity correction of 20 percent to 25 percent. (Stocks are still up 200 percent from the previous bottom.) Another mild recession would not be the end of the world; given how long it takes to revise economic data, it may turn out we've already been through one.

Fixed-income investors are subsidizing irresponsible lending, and getting too little return for it. Moreover, it makes no sense to try to solve a debt crisis by lending more money (a reality that seems to have eluded Europe, Japan and China). Writedowns can be painful, but they instill a sense of responsibility -- the kind that hasn't existed in the bond market for more than a decade, as investors have learned to count on government bailouts.

If the Taylor Rule -- a practical recommendation on setting nominal interest rates -- were taken more seriously, the Fed would have lifted overnight rates back up to the 2.5 percent range years ago. This would generate at least a trillion dollars annually, if not more, for fixed-income investors -- and a possible boost of 6 percent to GDP. The average American wouldn't likely suffer, because credit-card interest rates still average 13 percent and, given a likely flattening of the yield curve, mortgage rates would barely increase.

And while some people will worry that higher interest rates could exacerbate trade problems, a 2 percent differential is not all that relevant to currency fluctuations. Even without a change in overnight lending rates over the past few years, the dollar-to-euro exchange rate has varied by 10 percent to 20 percent annually.

So let's end the era of the "Greenspan put" and Bernanke's quantitative easing, and return to basics. The Fed should raise rates 0.25 percent this September and 0.50 percent thereafter. Already this century, the Fed has helped enable two bubbles that resulted in equity corrections of 40 percent and 50 percent. Investors would be wise to remember that if the Fed doesn't raise rates now.

Source: Why the Fed Should Raise Rates Now - Bloomberg View

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