In the column dated December 16, 2015, I had said that the Federal Reserve of the United States would raise the federal funds rate, at the end of its meeting which was scheduled on December 15-16, 2015. That was the easy bit given that Janet Yellen, chairperson of the Federal Reserve of the United States, had more or less made this clear in a speech she made on December 3, 2015.
The Federal Open Market Committee(FOMC) of the Federal Reserve of the United States raised the federal funds rate by 25 basis points (one basis point is one hundredth of a percentage) to be in the range of 0.25-0.5%. Earlier, the federal funds rate moved in the range of 0-0.25%. FOMC is a committee within the Federal Reserve which runs the monetary policy of the United States
The federal funds rate is the interest rate at which one bank lends funds maintained at the Federal Reserve to another bank on an overnight basis. It acts as a sort of a benchmark for the interest rates that banks charge on their short and medium term loans. This is the first time that the FOMC has raised the federal funds rate since mid-2006.
I had also said that the Yellen led FOMC would make it very clear that the increase in the federal funds rate would happen at a very gradual pace. The statement released by the FOMC said that it expects the “economic conditions will evolve in a manner that will warrant only gradual increases in the federal funds rate; the federal funds rate is likely to remain, for some time, below levels that are expected to prevail in the longer run.”
As Yellen put it in central banking parlance in the press conference that followed the Federal Reserve meeting: “The monetary policy will continue to remain accomodative”. In fact, the members of the FOMC expect the federal funds rate to be at 1.4% in a year, 2.4% in two years and 3.3% in three years.
If the federal funds rate has to be at 1.4% one year down the line, then it means that the FOMC will have to raise the federal funds rate by around 25 basis points each (one basis point is one hundredth of a percentage) four times next year. This seems to be a little difficult given that the presidential elections are scheduled in the United States next year. Also, there are other problems that this could create.
The low interest rate policy was unleashed by the Federal Reserve in the aftermath of the financial crisis which started in September 2008, when Lehman Brothers, the fourth largest investment bank on Wall Street went bust. The hope was that both households and corporations would borrow and spend more and in the process, economic growth would return.
What has happened? The household debt to gross domestic product(GDP) ratio has been falling since the beginning of 2009 as can be seen from the accompanying chart.
The household debt to GDP ratio has fallen from around 98% of the GDP at the beginning of 2009, around the time the financial crisis had just started to around 79.8% of the GDP now. What this tells us is that the household debt as a proportion of the total economy has come down. This despite low interest rates being prevalent when at least theoretically people should have borrowed and spent more money.
Take a look at the following chart. It shows that the proportion of the disposable income that Americans are paying to service their debts has also improved. In end 2007, Americans were spending 13.1% of their disposable income to service debt. It has since fallen to 10.1%, though it has jumped a little in the recent past. But the broader trend is clearly down.
What these two graphs tell us clearly is that the household debt in the United States has come down in the aftermath of the financial crisis. So if households have not been borrowing who has? The answer is corporates.
As Albert Edwards of Societe Generale wrote in a research note in November: “The primary driver for the rapid rise in bank lending…has been borrowing by US corporates and we all know they have been using the Fed’s free money not to invest in capacity expanding expenditures, but rather to buy back mountains of their own shares…Corporate debt borrowing at an $674bn annual rate [is] closing in rapidly on the all-time borrowing splurge of 2007!”
In another note released after the FOMC decision to raise the federal funds rate Edwards writes that “the real rate of corporate borrowing is even greater than was seen during the late 1990s tech bubble.”
American corporates have borrowed at rock bottom interest rates not to expand their capacities by building more factories among other things, but to buy back their shares. When a corporate buys back and extinguishes its own shares, fewer number of shares remain in the open market. This pushes up the earnings per share of the company. This in turn pushes up the share price. A higher earnings per share leads to a higher market price.
As a result of all this borrowing, the US corporate debt has reached 70% of the GDP, around the level it was at the time the financial crisis started. A Goldman Sachs research note points out that between 2007 and now, the total borrowing of the US corporates has doubled.
Nevertheless, all this money needs to be repaid. And this will become increasingly difficult with sales of US corporates falling. As Edwards writes in his latest research note: “It doesn’t help that both corporate profits and revenues are now falling…Nominal business sales have been contracting all year. Originally, it was put down to unseasonably cold weather – but the chilly data has just not gone away, as a combination of unit labour costs and weak pricing power have led to a typical late cycle decline in profit margins.”
If the Federal Reserve keeps increasing the federal funds rate, the interest rate that American corporates need to pay on their debt will keep going up as well.
The interest rate that the American corporates have been paying on their debt has fallen from 6% in 2009 to around 4% in 2015. A higher interest rate would mean a further fall in the profit made by American companies. Lower earnings would lead to lower stock prices and lower broader index levels.
And this is not something that the Federal Reserve would want. A falling stock market because of higher interest rates would jeopardise the American economic recovery.
As Yellen said in her speech earlier this month: “Household spending growth has been particularly solid in 2015, with purchases of new motor vehicles especially strong….Increases in home values and stock market prices in recent years, along with reductions in debt, have pushed up the net worth of households, which also supports consumer spending. Finally, interest rates for borrowers remain low, due in part to the FOMC’s accommodative monetary policy, and these low rates appear to have been especially relevant for consumers considering the purchase of durable good.”
Once we factor in all this, it is safe to say that the Federal Reserve will go really slow at increasing interest rates. In fact, I don’t see it increasing the federal funds rate to 1.4% by the end of next year. This means good news for Indian stock and bond markets, at least for the time being.
The column originally appeared on The Daily Reckoning on December 18, 2015