The Fed has all but promised to increase rates at the March meeting, and if it does, there will likely be adverse repercussions. The Yellen Fed is on the precipice of making the same mistake the Greenspan Fed did when it tried to control capital market prices by increasing rates. Greenspan had the dot-com bubble of the ’90s that he wanted to address. Remember when eyeballs on websites were more important than corporate earnings, and companies changed their name to whatever.com just so they could raise capital? Today, we have the Trump stock rally.
It doesn’t seem to matter what line of business your company is in — if you have investors, your investors are betting on growth. Love him or hate him, investors view the expected Trump policies to be good for business and good for growth. The stock market is all the evidence you need. Post-election the DOW experienced two records: hitting 20,000 for the first time, then shortly thereafter 21,000.
During the dot-com bubble, investors assumed eyeballs would turn into earnings; they didn’t. The Trump rally assumes reduced regulation, lower taxes, and less red-tape will result in growth. It could, but then again it might not. The truth is we have no idea what the impact will be. Because we don’t have enough information about the new administration’s economic and other policies to gauge how the economy will be impacted, it’s dangerous to assume the impact. To make such an assumption is really a “hope” trade; not unlike the eyeball assumption of the late ’90s. Today’s investors believe the business environment will improve to such an extent that increased growth is inevitable.
The problem is that the Fed seems to have become completely distracted with the huge run-up in capital market values (just as in the ’90s). However, today’s economy has been on a slow burn recovery for the last six+ years. Unemployment and non-farm payrolls have been improving, and GDP, while anemic, has been positive. Nothing points to a material departure from this in 2017 other than the “hope” trade we see in the capital markets. I think we can all acknowledge the Fed needs to raise rates to get back to “normal,” but a slow, deliberate pace is still best given the latent fragility in the economy. This talk of at least three hikes is concerning. As many as two rate hikes could possibly be rationalized in 2017. However, they should both take place towards the end of the year, when we have better visibility and a deeper understanding of the new administration’s economic policies. One economist theorized that the only reason the Fed is contemplating a hike is because nothing else has gone wrong in the economy.
I agree, a slow burn recovery remains the status quo for 2017, leading to a natural conclusion that a slow pace of increasing rates (as we experienced in 2015 and 2016) would be the most prudent course of action. Against this backdrop, if the Fed proceeds with a materially more aggressive rate hike posture, it runs the risk of slowing the economy along multiple vectors: employment, business investment, GDP, and trade — harming the economy, not protecting it from inflation. In the ’90s during the dot-com bubble, the Fed thought it could control the irrational exuberance by raising rates and therefore driving down dot-com stock prices. The Fed was wrong. It weakened the economy — and when the dot-com bubble did burst, the recession was much worse. Ultimately, it’s difficult for a rational action to adequately address an irrational problem. Not dissimilar, today’s Fed believes capital markets are overvalued and is using this fact as 1) additional support to increase rates; and 2) as a means to control valuations. If it was to raise rates, the move would be even less successful than it was back in the ’90s, as investors would likely interpret a March rate hike as supporting their notion of expansive economic growth being inevitable.
While accelerated growth is possible if the right economic policies are enacted, it’s too soon to make this assumption. Current economic trends do not support this notion, as the slow burn recovery continues. Just as with the dot-com bubble in the ’90s, at some point, investors will realize their “hope” trade is exactly that — “hope,” and the market will pull back. And, if the Fed has increased rates once or twice before the pullback occurs, the economy will have already been substantially weakened, combining the psychologies of weak economic stats and retreating capital markets and possibly setting the stage for a dot-bomb-like recession.
If the Fed were to ask me for advice (and it has not), I would urge it to wait to make a hike decision until the third quarter. At that point, we will have a much better idea of new economic policy and the timing of such. With the slow burn recovery in place, the risk of inflation remains low if the Fed moves late, but if it moves too quickly the threat of recession and its severity are materially increased.
Todd Harris is President and CEO of Silicon Valley-based credit union Tech CU.
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