Could rate hikes derail the US economy?

The US economy is booming, but there are concerns that the Fed's tightening of its monetary policy could spook markets and take the recovery off course.

Third quarter economic growth came in at 5 per cent for the US, a rate double the historical average. On any measure the US economy is booming. This isn’t some modest growth profile or a tentative recovery; it’s booming. 

Indeed the third quarter outcome is the fourth such quarter of growth since mid-2013, the exception being weather distorted quarter early this year. On average, the US economy has expanded by 4.4 per cent over those quarters. That’s an incredible rate of growth. So much for the idea of secular stagnation!

The big question going into 2015 and a key market concern is whether that growth can be sustained. Fortunately, early indications are good. Lead indicators are very positive: jobless claims are very low and point to further sharp drops in the unemployment rate in coming months, perhaps as low as 5 per cent (currently 5.8 per cent).

Then, we find that economic growth is broad-based; that is it’s not unbalanced or unstable. Consumer spending is healthy though not excessive. Business investment is strong, as is export growth. Then we find that residential investment has picked up.  

The issue that has got markets a little concerned (if not spooked in some quarters) is whether the US economy will prove resilient in the face of a long-awaited lift in interest rates. Expectations are that the Fed will start to hike rates this year. Just going on the forecasts from the Fed presidents, rate hikes could be quite aggressive, with the FOMC participants looking for a funds rate up around 1 per cent by the end of 2015.

The first thing to note is that at ultra-low rates, monetary policy is largely ineffective. More specifically, changes in monetary policy are ineffective. The fact is, rates are currently so low that any increase (assuming 25 basis points hikes) or even a further reduction would barely register in the minds of consumers or business.

Take the last tightening cycle in mid-2004. At the time, rates were 1 per cent and over the following 18 months, the Fed raised the target funds rate by 275 basis points to 3.75 per cent. These days, that’d be enough to spark panic in the minds of some commentators. Back then, people seemed a little more resilient. So that hike in rates saw no discernible change in economic growth outcomes (on average over the ensuing two years). In fact, jobs gains actually accelerated as rates were increased and the unemployment rate kept falling, from about 5.7 per cent at the time of the first hike to a 2005 low of 4.9 per cent (and a cycle low of 4.4 per cnet in 2006 and 2007).

That’s obviously not to suggest that rate hikes cause economic activity to accelerate. Although, having said that, a strong case could be made that the confidence policymakers express in hiking rates -- from very low levels -- instills confidence in the rest of the economy. Certainly the US housing market continued to boom as rates pushed higher and house prices and housing starts only peaked about two years after the tightening cycle began. All that proves my point that from ultra-low levels rising interest rates don’t register.

With that in mind and as historical experience shows, markets don’t need to worry about how rate hikes might affect the US economy. Chances are they won’t -- not for a while at least - and that’s not to forget the very strong chance the Fed doesn’t even start tightening this year at all.

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