"I'll build a stairway to Paradise," promised songwriter George Gershwin decades ago. Fed chairwoman Janet Yellen is about to try to do the same, taking interest rates up that stairway, from the zero level set during the hellish days of the financial crisis to the Paradise of normality or near-normality. There is almost unanimous agreement – an 85 percent probability according to markets -- that next week the Federal Reserve Board's monetary policy committee will raise interest rates by 0.25 percent, bringing the era of zero interest rates to an end. Unless, of course, Yellen & Co. belie the hints its chair has been dropping and double-cross the markets.
Yawn if you will, and with reason: There is unlikely to be any serious impact of such a move. Yes, money will cost a bit more for borrowers who plan to buy houses and cars, but home sales are being driven primarily by improving labor markets, and vehicle sales by those better jobs prospects and cheap gas. And yes, some investors will mourn the end of their love affair with zero rates, but that grief has already been "priced into" their decisions: every investor and businessman with whom I have spoken has already taken into account the zeroing out of zero rates in his decision making. And yes, investors in junk bonds, watching the Third Avenue Focused Credit Fund liquidate after shrinking from $2.5 billion to $788 million, are in a nervous sweat, but they had to know that high yields came with similarly high risk. Having turned their inheritance over to strangers, they are reaping the whirlwind.
But two groups are cheering. One includes those who feared that continuing the zero-rate policy would eventually trigger inflation, asset bubbles that would eventually pop, and a massive misallocation of capital. For them, this week's probable rise is the welcome start of a "great recalibration". The other now-happier group consists of observers who see normalization of interest rates as an expression of Fed confidence that the U.S. economy is headed to broad, sunny uplands after a serious recession and a halting recovery. Economists surveyed by the Wall Street Journal expect that rising rates will not prevent economic growth next year from accelerating to an annual rate of 2.6 percent, compared with 2.2 percent this year. And that survey was taken before yesterday's announcement that November retail sales had surprised on the upside. Never mind that
* the Fed has a history of excessively optimistic forecasts, or that
* the manufacturing sector is struggling, or that,
* as Yellen recognizes, headwinds blowing from China, Europe, Brazil and other places might leave the economic recovery too fragile to withstand successive increases in interest rates.
If rates are raised next week, the increase will be only the first step on a climb up a stairway to interest rates more than three full percentage points higher than they now are. The last time the Fed decided to raise rates – to tighten, in economists' jargon – was in 2004. By June of 2006 it had initiated seventeen rises, each of 0.25 percent, taking its benchmark rate from 1 percent to 5-1/4 percent, in the process surprising markets which, according to a study by the Federal Reserve Bank of San Francisco, "expected an even more gradual pace for the policy tightening that actually occurred."
This time around Yellen has promised a "shallower glide path", and one that will not take rates all the way up to a normal level because of lingering ailments from the financial crisis – difficulties many people have in obtaining mortgages and small businesses have in obtaining credit, households' on-going need to repair their balance sheets, weaknesses in overseas economies. The Fed is guessing – and here I use the guess that is in the middle of the Fed's range of predictions – that this new round, if that is what it proves to be, will take rates to 1.375 percent in December 2016, 2.625 percent in late 2007, and 3.375 percent in 2018, settling at about 3.5 percent in the longer run. Since it expects the rate of inflation to have moved up to around 2 percent by that time, the real, inflation-adjusted rate will be about 1.5 percent. Of course, if the economy slows significantly either because of or merely coincident with the coming 0.25 percent rate rise, a self-styled data-driven Yellen will call a halt on the first step of her stairway to normality – and try to hold off congressional critics looking for an excuse to reduce the Fed's independence. But short of such a development, the significance of the coming rate rise will come not from its direct impact on the economy, but from the effect of the series of increases that are now likely to follow, and the anticipation of those increases.
Much will depend on the policies of Mario Draghi, head of the European Central Bank, and his fellow central bankers. Marc Summerlin, managing partner of Evenflow Macro, DC-based economic consultants, tells me, "With other major central banks keeping interest rates at zero or below, the Fed will be challenged in getting all the way back to the long-run neutral rate … before the next recession starts." That challenge will become even greater if Draghi et al. choose to lower their interest rates further, driving down the value of their currencies against an already-strong dollar. Recall that Super Mario's recent effort to drive down the euro undershot expectations, leaving it higher than he had hoped, making renewed efforts to depreciate that currency likely. And the Fed's job of keeping the American economy growing in a rising-rate environment won't be made easier if China's rulers continue to "guide" – a term they prefer to "manipulate" – their currency down against the dollar. The yuan has already been guided 3 percent lower in only four months as the regime attempts to cope with falling competitiveness and layoffs resulting from a round of wage increases. Given a choice between more downward guidance and increasingly restive masses, Xi Jinping will opt for the former.
American exporters are not the only ones watching the strengthened dollar with concern. When the U.S. central bank starts to climb the stairway to a more normal interest-rate level, many developing economies begin to gasp for breath. They have borrowed in dollars, and have to buy dollars with their own currencies in order to pay interest and repay loans. With the dollar rising, or their own currencies depreciating in value, it costs them more to get the dollars they need. Also, a rising dollar unleashes a flight to safety – a dumping of local currencies in order to buy dollars, a capital flight that can cripple emerging economies. Finally, a stronger dollar reduces the beneficial effect of lower crude oil prices on other economies, which have to buy dollars to pay for crude, which is traded in dollars.
Yellen has balanced all the now-foreseeable effects of the new policy, which likely do not include all that will eventually result, and decided to follow the path laid out by Mr. Gershwin, "I'll build a stairway to Paradise with a new step ev'ry day! I'm gonna get there at any price; Stand aside, I'm on my way!" I'm not sure of the "any price" part.