As the arbiter of monetary policy for the largest economy in the world, the Federal Reserve is usually thought of as having a pretty solid grasp on all things economic.
According to David Kelly, chief global strategist at JP Morgan, however, the way that the Fed is approaching interest rate hikes shows a lack of economic understanding.
“I honestly think they have misunderstood a rate hike’s effect on the market,” he told Business Insider.
“They’re all smart people and well intentioned, but I don’t know that there has been enough investigation into the nonlinear response of the market to interest rates.”
To Kelly, the Fed has approached the issue of hiking interest rates, which could come as early as next week, the wrong way. The basic way of understanding Federal Reserve interest rates is lowering the rates makes it cheaper to borrow money, stimulating the economy.
If you hike rates, this slows the rate of lending and spending, helping to cool an economy that may be running too hot and approaching bubble territory.
It’s not that simple, says Kelly.
“Raising rates at this point tends to bring business forward,” he said. “When you raise rates from a low level, we estimate that getting to 1% [Fed funds rate] would add $60 billion coming in on interest income, helping to grow the economy.”
With interest rates as low as they are, making money from loans is more difficult. According to Kelly, the $60 billion from the increase would more than offset any slowdown in business activity.
Additionally, said Kelly, from a psychological standpoint an increase in rates would be a strong signal of confidence in the economy. This then would encourage more investment.
A drawback of raising rates is the impact on the housing market. If you have higher rates, mortgages are more difficult to pay and obtain, slowing down a driver of the economy. Kelly dissents:
“A big negative of raising rates is the housing markets. But, if you think about it you need three things to have a house: ability to pay a mortgage, a down payment and a FICO credit score. The last two are unaffected by interest rates and you’re really not going to stop being able to pay for it because of an increase in interest rates to 0.5% from 0%.”
He said the real concern when interest rates are much higher, such as raising from 7% to 8% because you’re pricing out a larger portion of the potential homebuying pool.
There are a lot of reasons to think that a Fed rate increase cold be good for the economy, Kelly emphasised, and the economy is probably ready for a normal pace of hiking rather than the slow and steady one promised.
The reasons for the worry, Kelly told us, is that the Fed simply isn’t putting in the work to understand a hike beyond the basics.
“They tend to talk in generalities, to look at it in that same linear pattern,” he said. “There’s just no serious work being done on the nonlinear realities of how the market will move on a rate hike.”
Kelly is ready for the rate hike, and he expects the markets are too. It’s just the Fed that needs to get the confidence to move.
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