Fed rate hike will hurt US economy

After six years of stimulus, the US economy is still nowhere close to escape velocity. For 36 consecutive months, the core PCE (personal consumption expenditure, the Fed’s favourite measure for inflation) index has failed to hit the Fed’s 2 per cent target.

This is worrisome, given the over-loaded debt burden faced by America: in the absence of runaway growth, inflation is arguably the best mechanism over time through which the real value of debt can be systematically eroded.

After a brief period of deleveraging following 2008, levels of private and public sector debt today are higher than they have ever been ($42 trillion and $18 trillion respectively).

With debt at these unprecedented levels, it will become impossible for this economy to cope with even small rate rises, leave alone a possible move to 3 per cent as indicated by some Fed models.

To put it in perspective, a 300 bps hike in interest rates will increase interest payments on the public portion of the government debt (approximately $12 trillion) by $360 billion annually — eliminating the current 2 per cent annual real GDP growth rates.

Facing this predicament, the Fed needs to declare to the market that the terminal Fed Funds rate in this cycle (2017-18) is unlikely to pass 1.5-2.0 per cent. Rather than talking about raising interest rates, they actually need to polish their macro prudential tool kit instead.

The only reason that this Federal Reserve is focused on raising rates has to do with the exuberance that many asset markets have exhibited since the QE programmes began.

The Fed is worried whether this exuberance, if unchecked, will engender a crisis similar to that which the world went through in 2008. This problem for the Fed was created the moment it chose a path of QE in which asset markets were picked as the transmission mechanism for confidence creation and, therefore, growth.

What are the options before the Fed now? In the last 12 months the dollar has strengthened 20 per cent against many currencies. This has acted as a quasi-monetary tightening for the US.

The strong dollar has dampened inflation and shaved off almost a full percentage point of growth through the impact on the trade account. Against this backdrop, the Fed raising rates further will bring a tepid economy to a complete standstill.

One thing is certain: the US economy today is in no position to cope with a 20 per cent price correction in the equity markets either: a correction that size would wipe out $4 trillion of aggregate wealth and send the US into a deep recession. It would unwind the progress made in the job market during the last three years and freeze businesses from hiring.

Any rate increases by the Fed at this stage, to show they were able to, will do precisely this. It’s difficult to conceive how any sensible CFO in a Fortune 500 company would be willing to invest in capital projects today given the hawkish rhetoric about the Fed raising interest rates. Especially when the backdrop for global growth also looks fairly challenged.

The one action for the Fed to implement here is to create a macro environment in which markets are effectively collared.

The famous Fed Put, which protected markets to the downside, now needs to work in conjunction with a Cap which prevents significant moves up in asset prices as a result of speculation.

Any appreciation to equity markets at this stage of the cycle should be driven by asset fundamentals, rather than money flows and risk posture.

The best way for this Fed to accomplish this is to start sharpening its macro prudential tool kit.

Raising margin requirements for levered asset classes is a good first step. The Fed working with regulators of other securities markets needs to implement a carefully thought through plan to identify specific assets where inherent leverage is rampant, and take concrete steps to deleverage these assets gradually.

This would help reduce the unwarranted risk-taking that often prevails in the later stages of financial-market exuberance.

This plan should mandate financial institutions to set aside incremental capital (from today’s levels) for the explicit purpose of financing highly leveraged credit instruments, illiquid securities and complex derivatives.

The current leverage available on four of the largest traded instruments — US treasury securities, S&P 500 futures, levered credit and currency instruments — all foster unwarranted speculation. In addition, many investors searching for yield are hiding in investment strategies which have very small embedded returns on assets but are then leveraged to the hilt to get adequate returns on equity.

A liquidity crisis will exacerbate market movements to the downside. Similarly regulatory arbitrage-based “shadow lending” activities currently engaged in by thinly capitalised unregulated entities serve little to no purpose in an economy the size of the US.

All such activities need to be curbed now.

Raising margins and truncating excess leverage even by a single turn, economy-wide, will help remove the fringe players, curb speculation and dampen euphoria.

It will cool asset price inflation and will send a strong signal from the Fed discouraging the formation of bubbles.

History tells us that the next blow-up will most likely come from a place that no one — including the Federal Reserve — anticipates.

Implementing prudent leverage ratios and regulating credit is the best way to collar markets at this stage and prevent a financial meltdown.

This gives the Fed flexibility to watch incoming data without having to raise rates, only to lower them subsequently — thereby losing credibility.

At this stage, protecting the Fed’s credibility is safeguarding their best asset.

The writer is the chief executive officer of Meru Capital group

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