Why The Fed Likely Won't Raise Interest Rates Now - But Why It SHOULD

The news this morning in The Financial Times that the World Bank has warned the U.S. Federal Reserve not to raise interest rates at its September meeting, is depressing to say the least. The reason given is that such a raise (only 25 basis points, or 0.25%) would "create turmoil in global markets" especially after the Chinese devalued their Yuan, and hence would bring "chaos" to emerging markets.

Of course, this is rubbish, merely more flatulence to support the speculators who are high on equities' crack, and the Fed's quantitative easing (QE).  Whether the Chinese manipulated their currency to gain an advantage (cheaper Chinese goods) is their business, and they have to live with the fallout - or benefits such as they are. But for the U.S. to hold back any rate increase because of fear of roiling emerging markets is bloody bollocks. (Especially as the FT later reported the emerging markets were calling for a Fed rate increase!)

It isn't very often I agree with conservative economics guru Martin Feldstein, but I do now (cf. 'The Fed's Stock-Price Correction', Aug. 25, p. A11)  as when he writes:

"Market participants know that the economy is now essentially at full employment, that the consumer price index is close to 2 percent and that there is little risk of deflation. They know therefore that interest rates must rise, and that a return to normal levels will reverse the mispricing of assets. The Fed cannot hide that realization by postponing rate hikes for a few more months. And so the Fed should get on with the task of normalizing rates, particularly so investors and lenders are no longer tempted to sink deeper into mispriced assets."

There is a lot here to unpack, so let's begin by examining the claim of "mispriced assets" which to me represents (as it does to Feldstein) the central core of why rates must go up.

Right now those in the stock market, especially in equities, are riding a huge asset bubble. The bubble has two components that are perilous but which too few - high on the nose candy of their share prices - ignore. One is the very excess price of equities, or more exactly, the high price to earnings (P/E) ratio of most of them. The rapid rise has already foreshadowed one shot over the bow - the recent 12 percent correction (-1200 pt. plunge) in the DOW, that ought to have signaled to any sentient person he was holding mispriced assets. But after the initial plunge, the DOW bounced right back up and every maniacs has since forgotten about it.

As Feldstein also noted (ibid.) while these same investors may have realized the rapid increase in share prices was a bubble waiting to pop - they still invested on the mistaken belief they would know when to pull out, But in more than 90 percent of cases ordinary investors really have no clue when to pull out. Their emotions generally lead them astray.

Market timing has never been developed into a high art, and only a fool would believe he or she can practice it reliably.

The other worrisome aspect is that other mispriced assets, including real estate are afloat, As Feldstein notes (ibid.):

"As investors reached for yield in a very low yield environment the spreads between Treasury rates they depressed the yields on high risk bonds and emerging market debt. The prices of commercial real estate have also been pushed to extremely high levels, driving down yields to unsustainably low levels."

Most worrisome:

"Banks and other lenders have boosted their short term earnings by lending to lower quality buyers and making loans with fewer conditions."

Echoes of the 2008 financial meltdown, anyone? Recall the credit crisis was hatched by sub-prime lending gone wild. Even Feldstein is worried as he frets that there may well be "adverse systemic effects" such as transpired in 2007-08.

Let us hope not! But understand this: the introduction of a Fed rate increase is a badly needed dose of medicine right now, to temper the mispricing that's characterized this boom cycle. And the longer the Fed delays administering the medicine, the worse will be the reaction when it finally is given.

As Feldstein puts it (ibid.):

"It's time to escape the unprecedented monetary policy that for a while stimulated demand - but then distorted prices and brought about the current corrections."

Lastly, if the Fed refuses to raise rates at this month's meeting, and the economy really does come a cropper, it will have no wiggle room at all. None, nada. Unless they want to go into negative interest rate territory!