When the US economy crashed in 2007-09 following the sub-prime crisis, the banking system froze. The Fed brought its interest down to 0% and effectively ‘doped’ the economy for 8 years with very cheap money. This ended this Wednesday, the 16th, when the Fed increased its rate for the time since the crisis by a smallish 0.25%.
It looks like non-event and by itself it is. What is represents, however, is a big deal.
A sick patient
In the aftermath of 2007-09 and the collapse of Lehman Brothers, a huge issue of trust prevented the system from working properly. Banks would net lend money to each others, liquidity was missing and many businesses saw their lifeline cut. Bankruptcies followed, increasing the trust issue and re-inforcing the problem.
When businesses borrow money from the banks, the banks themselves get their borrowings from the Fed. The basic cost of borrowing comes from the interest rate the Fed applies on funds that the banks leave with the Fed overnight.
Technically, it’s the best and lowest interest rate available on the market so everything else is priced based on that rate: mortgage rates (eg. 30 years), car loans (eg. 5 years) and credit card rates (eg. 1 month). But savings rate (consumers lending to the bank) are also affected by this rate.
And a powerful medicine
Prior to the 2007-09 crisis, the Fed’s rate was set at 5.25%, meaning this was the cheapest rate at which the banks could borrow cash overnight. After the crisis started, to boost liquidity and promote lending, the Fed decreased its lending rate 10 times in 14 months to almost 0%.
This dramatic decrease remained within the 0% – 0.25% range for almost 6 years.
With all this cheap money and the subsequent Quantitative Easing, debt became very cheap and the housing market started to turn around. Companies borrowed at very low levels, regained confidence and started to hire again. Unemployment has fallen dramatically and companies are now making record profits.
Debt is so cheap that companies have started to borrow to buy-back their shares to boost EPS, pushing stock prices higher still. Awash with debt and equity, M&A deals have accelerated. Too much of a good thing can be dangerous and the Fed is also aware of that.
What comes down must go up
All this cheap money has been a boost to the economy and lowering interest rates is one of the easiest ways a central bank can control inflation and therefore growth. When the economy stalls, it lower the rates to stimulate it. When the economy overheats, it increases the rates to cool it down.
As long as the rates are set at 0%, the Fed doesn’t have much leverage to dope the economy again were it to go into recession again. Additionally, when rates remain low for a prolonged period of time, inflation expectations also go down towards deflation. Deflation becomes a problem when people and business stop spending in anticipation of future costs being lower than the current costs. Another vicious circle that feeds itself. This is why the Fed has a target inflation of around 2%.
Why it’s a big deal
An increase of Fed rate by 0.25% is by no mean going to impact your life or mine tomorrow. Maybe mortgage rate will go up a little and possibly the interest that we get on our savings account will start to increase next year. But other than, impact is negligible.
What will be visible to you and me and every consumer is what comes next.
According to the latest’s FOMC minutes, the Fed’s expectations are that rates will keep increasing for the next 3 years:
- 2015: 0.4%
- 2016: 1.4%
- 2017: 2.6%
- 2018: 3.4%
In 2018, mortgage rates could be around 7-8% again. House prices should come down as a result. Savings account may finally generate more than 0.1%, making people more wiling to save. Bond yields will increase and as the risk associated to a 5% return decreases, investment in stocks should decrease as well. Stock prices should then be expected to grow more slowly, or not grow at all.
So the rate hike that the Fed triggered this Wednesday is no big event in itself.
But the indication that it is on a path to raising rates back to normal levels over the next few years is a significant change.
Till then, many of us still have a Christmas celebration to prepare and gifts to
buy wrap. Enjoy the good time with your friends and family. We are taking a 2-week break ourselves, starting this week-end and we will be back in January with lots of a good stuff. Stay tuned 🙂
Happy holidays everyone,