Why The Fed Shouldn't Wait to Raise Rates -Wells Fargo
There are risks involved in doing nothing two economists contend, referring to the Federal Reserve's signal at its March Open Market Committee (FOMC) meeting that it would further delay the first fed funds rate increase. Markets now anticipate that the hike will be in September rather than June, a timeline with which Wells Fargo Bank economists John E. Silvia and Michael A. Brown do not agree. In a special commentary the two said they find "the delay in Fed action concerning given the incentive effects of searching for higher yield and, in turn, the willingness of market actors to take on additional risk when interest rate expectations are flat." They argue that the Fed is behind the curve in lifting the short-term fed funds rate.
They content there are already signs of risk-taking behavior arising, at least in part from the easy monetary policy that has kept rates exceptionally low for so long. Increased risk-taking is a by-product of investors seeking higher yields and this is already playing out with large run-ups in high yield debt issuance and greater subprime lending, especially in the auto market. The two maintain that the longer the Fed waits, the greater the risk that these credit sectors become overheated and result in adverse economic effects.
They point to the recent past, when the Fed moved to counter the effects of the dot-com bust in 2001 by cutting the fed funds target rate, eventually to 1 percent, and leaving low rates in place until June 2003 - some 18 months after the end of what was an 8-month long 2001 recession. The result was an increase in risk-taking as investors looked for a higher yield, a demand that help support the appetite for subprime home mortgages, collateralized debt obligations, and other risky investments. The greater risk appetite also helped fuel a rapid growth in new home mortgages and asset price inflation, especially home values. And we know what happened then.
So, they ask, are we about to repeat the same mistakes? They appear to think so although this time the risk taking may be focused on areas other than housing. There is a rapid rise in mergers and acquisitions (M&A) activity which, since bottoming in 2009 has continued to climb, more than tripling as of the fourth quarter of 2014. And of course everyone is aware of the steady upward trajectory of the stock market. Silvia and Brown say that the recent increase in M&A deals is concerning because of the number that have been funded through the new issuance of riskier high yield debt. This type of issuance has increased significantly since the end of the recession for non-M&A deals, such as firms refinancing debt, as well.
Evidence suggests that a lot of the increased risk-taking is directly related to the nation's monetary policy of late but this greater "reach for yield" is not just an American phenomenon. The Bank of International Settlements (BIS) says global investors have snatched up large volumes of new corporate debt, particularly for lower-rated borrowers, at the same time equity markets reached new highs. The BIS also says some asset values are apparently decoupling from fundamentals, one indicator of a potential bubble.
Risk taking may be going on in other areas besides corporate debt and equity markets. The figure below shows the number of firms easing lending standards today (brown bars) compared to the percent of firms easing standards at the height of the bubble in 2006. This indicates that lending standards for many products have matched the easy ones of 2006 and student/auto, and asset-based lending standards today are being relaxed even more than then.
A great deal of subprime lending activity has taken place in the auto market and delinquencies there are apparently beginning to rise slightly. While large numbers of auto defaults won't bring down financial markets the way housing defaults did a few years ago there would be adverse impacts on the automobile sector and consumer spending resulting from repossessed cars coming onto the market.
The authors conclude that, as in prior cycles, the lengthy period of low rates leads to more risk-taking behavior on both the supply and demand sides of the credit markets and this risk appetite then begins to spill over to the credit sectors as it currently being displayed in the form of higher equity values, a surge in high yield debt issuance and easier credit lending standards and this, they say, will result in emerging imbalances in the credit markets.
"We have seen this story play out before over the last decade," they say, "and the story did not end well. We do not feel that the current credit imbalances are enough to cause a global financial crisis as was the case with the housing boom and bust. However, should delinquencies begin to rise for subprime consumer credit products, this signal would likely be enough to result in anticipated future disruptions to credit markets. The risks of the Fed doing nothing are indeed real, and we look to be poised to repeat the same mistakes of the past."