The United States Federal Reserve – the American equivalent of our Reserve Bank – has kept interest rates at around zero per cent for the past seven years.
To put that in perspective, Australian interest rates are at historic lows too, but the official cash rate here sits at 2 per cent (extremely low but relatively high from an international perspective).
That may all change at the end of this week.
Essentially the US Federal Reserve Board will meet together and try to work out – no doubt piling through reams of paper work containing thousands of mind-numbing statistics – whether the world’s biggest economy can cope without cheap money sloshing around the economy.
Where we’ve come from
So picture this, it’s approaching winter in the United States in 2008, and America is staring down the barrel of the biggest financial crisis since the Great Depression.
The economy has been crippled by a credit market that’s frozen. Some of the world’s biggest investment banks lining Wall Street have become essentially worthless and no one wants to lend money to anyone else. The financial system has ground to a halt.
To avoid what economists like to call “Moral Hazard”, US officials allow at least one huge bank, Lehman Brothers, to collapse.
It’s a message to say, ‘no one’s safe’… and ‘let that be a lesson to the rest of you’. The rest of the banks had to scramble to make deals with one another (join hands in a circle of love) or lean on gold old Uncle Sam.
And so it was that a ‘financial catastrophe’ was averted, but a crisis remained. It was time now for a strategy to revive a shell-shocked consumer, now in the grip of what was called the Global Financial Crisis or what they called overseas, the Great Recession.
A few years later the US Government would run out of money and would be forced to raise the debt ceiling (Congress agreed to borrow more money than was previously allowed).
That illustrates though that the government had little by the way of economic fire power. It was always going to be up to the US Federal Reserve to stimulate the economy and get everyday folks to spend money again.
The problem was that they (the consumer) didn’t want to spend money, nor did businesses. In fact the reality was quite the opposite. People hunkered down and saved.
The solution was to give banks money for ‘free’. Uncle Sam – essentially via the US Federal Reserve – bought up government bonds and corporate bonds. That had two effects.
It lowered interest rates to encourage borrowing, but it also made it more attractive for financial institutions to lend money out to businesses rather than investing in the bond market themselves (where yields had fallen).
If that’s too mind-bending for you, just know that all of a sudden most of the world’s big banks were now awash with cash from Uncle Sam and they were looking for somewhere to put it.
Unfortunately business and consumers were in no real rush to borrow so large wads of cash simply went into the share market. Money also went into the property market.
Did it work?
Now some argue that there’s nothing wrong with what happened. They argue that as the assets of mums and dads started to rise (increase in house prices and share portfolio), they would have more confidence to go out and spend.
After all, now that a few years have passed since the financial crisis, there are a fair amount of savings that can be drawn upon… right? Unfortunately not. Consumers and businesses remain largely reluctant to spend.
In Australia, as far as companies are concerned, even today they have become so used to their stock values rising (because of low interest rates) that they are handing out exorbitant dividends to keep investors interested in their stock. That is of course resulting in less spending by companies on equipment and machinery that will help them grow.
In essence, a low interest rate environment has boosted the stock market and that in turn has fuelled an appetite for rising stocks.
Without the demand to back that up, directors have turned to more inefficient ways (raising dividends) of keeping the value of their stock prices elevated.
In the US, it’s a slightly different story. Companies recently have been hit by a rising US dollar. Generally speaking though, stocks have risen in price on the back of low interest rates, despite a subdued economy producing low levels of revenue growth among companies in the S&P 500.
As far as Australian consumers are concerned, the figures show we’re only really spending money on things like clothes and cosmetics, and we’re avoiding spending on big-ticket items.
Banks want to lend to us but we’re not, by and large, taking the bait. Of course money is being lent out to property investors in the Sydney and Melbourne property markets.
The financial crisis resulted in a system-wide loss of confidence, and despite all efforts from policy makers, it largely remains the case. Property and share investors, however, continue to ride the boom that’s been created from cheap money.
Forget about me rabbiting on about the economy, what do the cold hard economic statistics show? And how will that affect the Federal Reserve’s decision on Thursday?
Well I have to say the numbers look pretty good. The US still has the largest nominal GDP in the world (a little over $18 trillion). At last check GDP was growing at around 3.7 per cent.
Inflation (pace of rising prices) sits at around 1.7 per cent (any lower than that and the Federal Reserve would be worrying about stalling the economy as they raise rates).
Finally, unemployment continues to fall – it’s currently around 5.1 per cent (well below Australia’s unemployment rate).
So that’s all good right? Not so fast.
As it turns out there are still tens of millions of folks that have giving up entirely on the American Dream. They’re on welfare. Some are out of the statistics altogether.
The number that always grabs my attention is the number of Americans still on food stamps. Last May USA Today was celebrating the fact that the number of Americans receiving food stamps fell below 46 million people for the first time in more than three years.
So it stands that double the entire Australian population still receive around $125 per month from the US government to go and buy groceries.
So no, the United States economy still isn’t ‘healthy’ again yet, in my view. There are many other distortions too like enormous US debt, and a bloated share market.
So will the Federal Reserve bite the bullet and raise interest rates?
The markets are betting there’s a 28 per cent chance that the rate will be lifted a quarter of a percentage point to a range of 0.25 to 0.5 per cent (remembering Australia’s cash rate is 2 per cent).
The number crunchers or ‘pointy heads’ are a bit more confident the Fed will tighten policy. Around half of the 81 economists surveyed by Bloomberg say the Fed will push ahead and raise rates.
I have to put my hand up and say I honestly don’t know what the Federal Reserve will do. I suspect it will signal very firmly that a rate rise is imminent to test the market reaction.
Should they raise? Can the economy take it?
Have you ever tried to get into a bath or spa of really hot water? You have to do it ever so gradually. That’s probably what the Federal Reserve will do.
It will probably raise rates by the smallest of margins every so often for the next few years.
The problem as it stands now though is that no one really knows if the economy is ready for a tightening in monetary policy (which is what a series of interest rate increases over time amounts to). Whichever way you look at it, it’s dangerous territory.
To make matters worse, two events in the last couple of months have muddied the waters in terms of how ready the world is to take on a potential disruption to America’s economic growth trajectory.
An abrupt devaluation of the yuan by Chinese authorities in August and renewed turmoil in global markets has worried both economists and portfolio managers.
Those Chinese market developments have already seen the Australian dollar tumble to multi-year lows and have seen global share markets flirt with bear market territory.
How will a US rate rise affect you and me?
If you have shares there is the potential for the value of those shares (if they track the market) to fall in value (especially if combined with more negative economic news out of China).
If you own property, I don’t think you will feel any impact at all.
If you’re planning a trip to the United States, your purchasing power could fall (if the rate rise produces another leg down in the Aussie dollar).
If you own any US assets at all (a bank account, property, business interests … whatever) the value of that asset will rise (as the exchange rate moves in your favour).
Indeed if you follow market developments, and you perceive more market volatility, heightened anxiety or just more chatter, at least you’ll know why!
It’s a big week for global markets. I hope nothing major eventuates, but there is the potential for some seismic shifts in global money flows. Best of luck.