Tags: interest rates | federal reserve | economy | stocks

The Economy Would Thrive With Higher Interest Rates

The Economy Would Thrive With Higher Interest Rates
Trader Patrick King on the floor of the New York Stock Exchange (John Minchillo/AP)

Peter Morici By Thursday, 09 May 2024 10:00 AM EDT Current | Bio | Archive

For too long, Federal Reserve policymakers have focused on when interest rates could be lowered to avoid a recession. Instead, long-term growth and stock values would be better supported by letting markets take rates higher.

The consensus among Fed policymakers is that the federal funds rate should eventually fall to about 2.6% from its current 5.33%.

That target is higher than what prevailed between the Global Financial Crisis and COVID but is still too low.

Nowadays, demands on available savings are greater.

The Congressional Budget Office estimates that the federal deficit will rise from 5.6% of GDP this year to 6.1% in 2034—much higher than 4.6% in 2019.

The youngest Baby Boomers are now 60. As they retire, they pull funds from tax-sheltered retirement accounts.

Artificial Intelligence requires prodigious investmentsNvidia’s expensive processors, data centers and enormous additions to the electrical grid.

Surging immigration is relieving labor supply constraints, but it requires more housing and other infrastructure and doesn’t bring a lot of additional capital.

Along with investments to transition to electric vehicles and build a greener electrical grid, these forces tax available savings and put upward pressure on interest rates.

Trend growth is potentially much higher than the 1.8% Fed policymakers assume.

AI should boost productivity and investment akin to the advent of the steam engine, electricity, automobile and computer.

Goldman Sachs optimistically estimates as much as a 1.5% annual boost to productivity growth.

More realistically, the attainable trend rate of growth should be closer to 2.8% than 1.8% if we are not overzealous about suppressing inflation.

Even Chairman Paul Volcker only managed to get inflation down to an average 3.8% the decade following his battle with the Great Inflation of the early 1980s.

Chairman Jerome Powell has said he would tolerate periods above 2% to compensate for periods below 2% but little about the opposite.

Consumer expectations for 5-year inflation, as surveyed by the University of Michigan and New York Federal Reserve, are between 2.5% and 3%.

Assuming inflation will be above 2.5% rather than 2% seems reasonable.

A better gauge for the adequacy of interest rates is the 10-year Treasury rate, because it provides the benchmark for business and consumer borrowing rates, As of this writing, it’s about 4.5%.

The yield on high-quality corporate debt fluctuates between 0.7% and 1.5% above that rate. It’s trading closer to 0.7%, anticipating that the Fed will eventually cut the federal funds rate and increase the availability of funds across all markets.

A good estimate of where the 10-year Treasury rate should be is the sum of expected inflation and economic growth—that’s in the neighborhood of 5% to 5.5%.

Inflation and interest rates were historically low between the GFC and COVID. Globalization kept goods prices down, permitting the Fed to support households and businesses with easy money in their recovery from the GFC.

The 40 years prior to the GFC, average inflation was 4.0% and the 10-year was Treasury rate 7.4%. Equities thrived—the S&P 500 averaged a 10.5% return.

In recent months, stocks have held up well in the face of inflation reports that put interest rate cuts further into the future.

Considering this record, the 3.5% March increase in the Consumer Price Index does not seem high.

High mortgage rates—currently the 30-year fixed rate is about 7.2%—is not what handicaps homebuyers and landlords.

Rather it’s barriers to building new housing—restrictive zoning and NINBY around large cities and rising material costs and skilled-worker shortages when construction picks up.

Cheaper mortgages don’t fix supply constraints but those do enable buyers to push up prices, leaving them and new investors in rental units no better off.

Cheap credit props up firms that should wind down. That ties up labor that would be better redeployed into new and expanding activities like AI infrastructure and software, electric vehicles, batteries and green energy.

Such damage to healthy capital reallocation is likely one reason the IMF study of more than 100 episodes across 56 countries found that central banks that lowered interest rates too soon after battling inflation endured both a resurgence of inflation and slower growth over the longer term.

If the Fed wants healthy growth, it should let the 10-year Treasury rate drift up and abandon its obsession with lowering the federal funds rate to stave off a short recession.

Lower rates might put off a recession, but those would harm the great transition to AI that will channel workers from mundane to more creative tasks and slow the creation of a carbon-neutral economy.

Economic growth and equities would do well, as they did before the GFC, with a market determined, realistic cost for capital—the Fed should let interest rates rise.

Peter Morici is an economist and emeritus business professor at the University of Maryland, and a national columnist.

© 2024 Newsmax Finance. All rights reserved.

For too long, Federal Reserve policymakers have focused on when interest rates could be lowered to avoid a recession. Instead, long-term growth and stock values would be better supported by letting markets take rates higher.
interest rates, federal reserve, economy, stocks
Thursday, 09 May 2024 10:00 AM
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