What if the Fed Can’t Raise Interest Rates? Why Near-Zero Is the New Normal.

By Lisa Beilfuss

Fed chief Jerome Powell, shown late last year, could find it difficult to start liftoff on interest rates, let alone ending bond buying. / Daniel Acker/Bloomberg


When it comes to Federal Reserve policy, investors are focused on the wrong question.

Investors continue to agonize over when the Fed will trim its $120 billion in monthly asset purchases, says Joe LaVorgna, chief economist for the Americas at Natixis, with anxiety rising after minutes from the Federal Open Market Committee’s April meeting showed some policy makers think taper discussions should begin in “upcoming meetings.” 

A more important question, LaVorgna says, is when will the Fed raise interest rates. 

More important still: whether the Fed actually can raise rates. 

Financial markets’ sensitivity to monetary policy has never been higher. 

The Fed’s balance sheet has doubled since the end of the last financial crisis, now 40% of gross domestic product. 

By buying massive amounts of bonds, the Fed has lowered rates and used asset prices—especially stocks—as the primary tool for monetary policy, says LaVorgna. 

That’s through the so-called wealth effect, or the tendency for consumers (two-thirds of GDP) to spend more as their assets grow. 

And so any correction in stock prices would negatively affect economic growth and thus prevent the Fed from tightening, he says.  

That’s not to mention the prospect of further fiscal stimulus, which itself would make tapering bond purchases a tall order. 

“Who would buy the potentially trillions of dollars of additional debt?” 

LaVorgna asks, as the Fed has become such a dominant force in the bond market.  

“The Fed’s balance sheet keeps growing and the stock market keeps rising,” he says. 

“Fearing a contractionary GDP effect from lower asset prices on future economic activity means the Fed may never be able to normalize interest rates,” LaVorgna says.

That’s one piece of the argument that the Fed may not be able to meaningfully lift interest rates. 

Another is the debt side of the equation. 

Consider the fact that the Fed was unable to lift rates above 2.5% during the last tightening cycle and had cut rates in several meetings before the pandemic prompted its emergency actions early last year. 

Since then, U.S. households, businesses, and the federal government have grown only more indebted.

Therein lies the conundrum. 

If the Fed tightens, the existing debt pile becomes more expensive to service, hampering economic growth. 

If the Fed doesn’t tighten, debt across households, companies and the government continues to grow, making it ever tougher for the Fed to move. 

That’s a particular problem if inflation is something more than transitory, casting doubt over the Fed’s ability to quell a potential price spiral.

The Fed has put itself in a box that will be difficult to get out of, especially if that economy’s growth rate slows next year—which is almost a certainty given this year’s reopening boom, LaVorgna says.

The upshot: tightening, via both tapering and interest-rate increases, may be much further away than the market currently expects. 

(The Fed has said it would keep rates unchanged through 2023, while investors are pricing in the first 0.25% rate increase by January 2023.) 

For now, that would translate into ongoing stock market gains, especially in rate-sensitive areas like technology. 

What that means for the economy is another question, and what it means for markets longer term is yet another.

“It would not surprise me if in the next crisis the Fed crosses the final red line and buys equities,” LaVorgna says, what he says would amount to a “leveraged Fed put,” based on the belief that the Fed will inevitably come to the market’s rescue.

Whatever the answers, the questions facing U.S. investors are bigger and more consequential than when tapering and rate liftoff might begin.   

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