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Why investors should stop worrying about higher interest rates

September 8, 2015

Vincent SuraceVincent Surace
Specialist Vincent Surace, left, directs trades in Salesforce Inc. on the floor of the New York Stock Exchange. Photograph by Richard Drew — AP

Uncertainty over when and if the Federal Reserve will raise interest rates heightened last week when August’s jobs report showed the economy added 50,000 fewer jobs than expected even while the unemployment rate fell to 5.1%. The economy seems to be improving and worsening at the same time, which has complicated investor’s expectations for what the Fed might do next.

But worried as the market is about higher rates, the fact is it really doesn’t matter.

The fear of higher interest rates is rooted primarily in its contractionary effect on lending and money supply. An increase in the cost of capital can hamper both consumption and manufacturing.

But even if that happens, it would simply be right-sizing the economy to current demand. After all, a small increase in borrowing costs shouldn’t prevent consumers from spending or deter a business that can sell more goods from increasing its capacity. The point is that at near zero interest rates, the U.S. has a lot of buffer on this front, so if there is a reduction in the economy, it will be because of a substantial disconnect between supply and demand.

Higher interest rates would simply help the U.S. avoid the trap of overproduction and asset bubbles fueled by excessive cheap debt. If that sounds familiar, it should. Those are precisely the challenges plaguing another large world economy: China.

 

Ironically, the selloff of U.S. stocks began a few weeks ago because of weakness in the Chinese economy, the devaluation of the yuan, and stock market turmoil in the Asian nation, which led to serious concerns about a global economic slowdown. So if the market believes that China’s problems are unlikely to be fixed soon, then it should welcome an increase in U.S. interest rates. It might hurt a little now but will bring the U.S. economy in line with global demand and prevent the creation of an asset bubble whose bursting could cause a lot more pain in the future.

On the other hand, if the Fed decides to delay raising rates, as the stock market is clearly hoping for, then it will give U.S. investors a chance to assess China’s moves to solve its economic problems over the next few months, and respond accordingly later on. That does have the benefit of propping up the U.S. stock market in the near future and enabling the Fed to navigate a soft landing for the U.S. taking into account rapidly changing global conditions.

In any case, no matter what decision the Fed makes in the coming weeks, the reality is that the U.S. economy will continue on its trajectory of growth (or not). The ‘bad’ scenario, namely the raising of interest rates this month, isn’t really bad at all. If anything, it’s the stock market’s knee-jerk reaction to it that’s the problem.

Then again, the more the market falls on the fear of an interest rate hike, the less likely it becomes that the Fed will pull the trigger on it in the near future, which will then push prices back up. So maybe there is a point to the market’s tantrum. It’s just creating its own reality.

S. Kumar is a tech and business commentator. He has worked in technology, media, and telecom investment banking.