The Interest Rate Conundrum

It’s time to invoke the parable of the fox and the hedgehog. You know – the hedgehog knows one thing, sees the world through the lens of a single commanding idea, while the fox knows many things, entertains diverse, even conflicting points of view.

This is apropos of my reaction to David Stockman’s The Fed’s Painted Itself Into The Most Dangerous Corner In History—–Why There Will Soon Be A Riot In The Casino.

Stockman, former Director of Office of Management and Budget under President Ronald Reagan who later launched into a volatile career in high finance (See currently lends his name to and writes for a spicy website called Contra Corner.

Stockman’s “Why There Will Soon Be a Riot in The Casino” pivots on an Op Ed by Lawrence Summers (Preparing for the next recession) as well as the following somewhat incredible chart, apparently developed from IMF data by Contra Corner researchers.


The storyline is that planetary production fell in current dollar terms in 2015. This isn’t because physical output or hours in service dropped, but because of the precipitous drop in commodity prices and the general pattern of deflation.

All this is apropos of the Fed’s coming decision to raise the federal funds rate from the zero bound (really from about 0.25 percent).

The logic is unassailable. As Summers (former US Treasury Secretary, former President of Harvard, and Professor of Economics at Harvard) writes –

U.S. and international experience suggests that once a recovery is mature, the odds that it will end within two years are about half and that it will end in less than three years are over two-thirds. Because normal growth is now below 2 percent rather than near 3 percent, as has been the case historically, the risk may even be greater now. While the risk of recession may seem remote given recent growth, it bears emphasizing that since World War II, no postwar recession has been predicted a year in advance by the Fed, the White House or the consensus forecast.


Historical experience suggests that when recession comes it is necessary to cut interest rates by more than 300 basis points. I agree with the market that the Fed likely will not be able to raise rates by 100 basis points a year without threatening to undermine the recovery. But even if this were possible, the chances are very high that recession will come before there is room to cut rates by enough to offset it. The knowledge that this is the case must surely reduce confidence and inhibit demand.

So let me rephrase this, to underline the points.

  1. Every business recovery has a finite length
  2. The current business recovery has gone on longer than most and probably will end within two or three years
  3. The US Federal Reserve, therefore, has a limited time in which to restore the federal funds rate to something like its historically “normal” levels
  4. But this means a rapid acceleration of interest rates over the next two to three years, something which almost inevitably will speed the onset of a business downturn and which could have alarming global implications
  5. Thus, the Fed probably will not be able to restore the federal funds rate – actually the only rate they directly control – to historically normal values
  6. Therefore, Fed tools to combat the next recession will be severely constrained.
  7. Given these facts and suppositions, secondary speculative/financial and other responses can arise which themselves can become major developments to deal with.

Header pic of fox and hedgehog from

Federal Reserve Plans to Raise Interest Rates

It is widely expected the US Federal Reserve Bank will raise the federal funds rate from its seven-year low below 0.25 percent to maybe 0.50 percent. Then, further increases will bring this key short term rate back in line with its historic profile gradually, depending on the health of the US economy and international factors.

This will probably occur next week at the meeting of the Federal Open Market Committee (FOMC), December 15-16.

Here’s a chart from the excellent St. Louis Federal Reserve data site (FRED) showing how unusual recent years are in terms of this key interest rate.


Shading in the chart indicates periods of recession.

Thus, the federal funds rate – which is the rate charged on overnight loans to banking members of the Federal Reserve system – was pushed to the zero bound as a response to the financial crisis and recession 2008-2009.

A December increase has been discussed by prominent members of the Federal Open Market Committee and, of course, in Janet Yellen’s testimony before the US Congress, December 3.

Yet discussion still considers the balance between ‘doves’ and ‘hawks’ on the FOMC. Next year, apparently, FOMC membership may shift toward more ‘hawks’ in voting positions – bankers who see inflation risks from the current recovery. See, for example, Richard Grossman’s Birdwatching at the Federal Reserve.

How far will interest rates rise? One way to address this is by considering the Fed funds futures contract. Currently, the CME futures data indicate a rise to 1.73% over the next 36 months.

All this seems long overdue, based on historical interest rate levels, but that does not stop some alarmist talk.

BIS Warns The Fed Rate Hike May Unleash The Biggest Dollar Margin Call In History

As a result, our only question for the upcoming Fed rate hike is how long it will take before the Fed, shortly after increasing rates by a modest 25 bps to “prove” to itself if not so much anyone else that the US economy is fine, will be forced to mainline trillions of dollars around the globe via swap lines for the second time in a row as the world experiences the biggest USD margin call in history.

By the end of next week or probably just after the first of 2016, interest rates may move a little from the zero bound, and from then on, one fulcrum of all business and economic forecasts will be the pace of further increases.