A June Fed Funds Rate Hike Risks a September Economic Stall
Recent economic data, e.g., retail sales, housing starts and industrial production, suggest that the U.S. economy has awoken from its winter slumber. In addition, growth in consumer prices has accelerated of late (see Chart 1). The consensus of the Federal Open Market Committee (FOMC) is that the federal funds rate will be hiked twice by 25 basis points each time in 2016. Time’s a wastin’. The behavior of short-term interest rates indicates that investors have been skeptical that the Fed will pull the fed-funds trigger at its June 14-15 FOMC meeting. But about a month ago, comments by Boston Fed President Eric Rosengren, no Johnny-One-Note policy hawk like Richmond Fed President Jeffrey Lacker, were interpreted to imply that financial-market participants were underestimating how soon the Fed might hike the federal funds interest rate.
Despite the recent acceleration in the pace of U.S. economic activity, I believe that the Fed runs the risk of causing the pace of U.S. economic activity to stall out in the late-summer or early-fall of 2016 if it raises the federal funds rate at its June 14-15 FOMC meeting. The reason I believe an economic stall would occur is, you guessed it, because of the negative effect a fed funds rate hike would have on growth in thin-air credit (the sum of the monetary base and depository institution credit).
Allow me to elaborate. The federal funds interest rate is the price of overnight credit in immediately-available funds, or reserves, created by the Fed. This price, like any price, is determined by supply and demand. The demand for reserves is determined by the amount of reserves depository institutions (primarily commercial banks) are required to hold in relation to their deposits. Depository institutions also have a demand for reserves in excess of what they are required to hold. Now that the Fed pays interest on reserves held by depository institutions, this excess demand for reserves is much higher than was the case when no interest was paid by the Fed on reserves. The supply of reserves is determined by the Fed. For example, if the Fed sells securities in the open market, the supply of reserves will decrease, all else the same. If the Fed wants the federal funds rate to rise, it needs toreduce the supply of reserves relative to the demand for reserves. When the Fed raisedthe federal funds rate in late December of 2015, the monetary base – the sum of reserves and currency in circulation – declined (see Chart 2). And, although the level of the monetary base rose subsequent to its dip coincident to the increase in the fed funds rate, the level of the monetary base has not returned to its level prior to the increase in the fed funds rate.
Now, let’s look at the recent behavior of a variant of thin-air credit, i.e., the sum of the monetary base and commercial bank credit. Chart 3 shows the annualized growth in this variant of thin-air credit on a three-month basis. In the three months ended October 2015, thin-air credit had grown at an annual rate of 6.7%, close to its long-run median annualized growth rate of about 7%. By the three months ended January 2016, annualized growth in thin-air credit had slowed to just 1.1%. In the three months ended April 2016, annualized growth in thin-air credit had recovered to 3.8%. But that was still well below its long-run median annualized growth of 7%.
Now let’s reproduce the data in Chart 3, the three-month annualized growth in thin-air credit, but also show the three-month annualized growth in its components, commercial bank credit and the monetary base. This is shown in Chart 4. We can see that in March and April 2016, the three-month annualized rate of growth in commercial bank credit has moderated (6.0% in the three-months ended April 2016). Although the monetary base still is contracting, its rate of contraction has become less, only minus 2.5% annualized in the three months ended April 2016. If the Fed raises the federal funds rate in June, the contraction in the monetary base will likely become more severe, as it did after the December 2015 hike in the federal funds rate. Unless growth in commercial bank credit surges for some reason, a June increase in the federal funds rate implies further slowing in the growth to total thin-air credit from an already slow rate of growth. In turn, this would imply future slowing in the pace of nominal economic activity from a none-to-robust current pace.
If the Fed decides to raise the federal funds rate in June, I would expect a rally in the prices of investment-grade U.S. bonds. At the same time, I would expect a decline in the prices of riskier financial assets.