Flirting with the Ceiling: A High-Level Overview of Interest Rates at an Inflection

A positive October CPI report raised hopes of the Fed finishing its rate-hike cycle. The odds for the December fed meeting shifted from a 15% chance of a hike to almost certainty of no move. First rate cuts are expected to begin in May 2024 with the market pricing in a 50 bps drop in June. It would take a horrendous November CPI report along with a rebound in payrolls to trigger another hike. The plan for a soft landing is apparently in place, according to multiple sources.

Let's dive into how we got here and weigh the options of 'higher for longer' interest rates versus rate cuts.

Pre-Pandemic Economic Conditions and the Fed's Action

Before the onset of the COVID-19 pandemic, the global economy was characterized by steady growth. However, the sudden outbreak of the highly contagious virus in early 2020 had profound consequences. Lockdowns and travel restrictions caused a significant drop in consumer spending, leading to a surge in unemployment rates and volatile fluctuations in interest rates.

In response to the pandemic's economic disruptions, Jerome Powell, Chairperson of the United States Federal Reserve, implemented a bold strategy. Interest rates were cut nearly to zero, which prompted a rapid rebound in the stock market and an overall economic resurgence. It's worth noting that this recovery was uneven, favoring the technology sector while tourism, travel, hospitality, and small businesses struggled. As a result of these actions and various economic challenges, concerns over inflation began to surface.

Unemployment rates in 2021 reached unprecedented levels, approximately 15%, surpassing the depths of the 2008 Financial Crisis. To address this issue, economic recovery relief programs were introduced, encompassing stimulus checks, historically low interest rates, and widespread vaccine rollouts.

The discussion on the Federal Reserve's approach to higher-for-longer interest rates presents a multifaceted issue. Two perspectives are essential to consider.

The Case for Higher Interest Rates for Longer

The first viewpoint supports higher-for-longer interest rates as a solution for controlling inflation. High-interest rates create a more restrictive economic environment by increasing borrowing costs for individuals, corporations, and governments. This, in turn, has a positive impact on spending and investment activity. It helps mitigate rapid price increases and supports long-term economic stability by discouraging excessive borrowing and speculative investments, ultimately reducing the risk of financial bubbles and crashes.

The above graph illustrates the impact of interest rates on investment and innovation in the venture capital sector. This shows the downward trend of global venture capital funding to angel-seed, early-stage, late-stage, and technology growth companies as interest rates began to rise from Q1 2021 to Q1 2023.

Additionally, global hedge funds in 2023 suffered the worst losses since the 2008 financial crisis, which can be attributed to a combination of factors, with interest rates playing a significant role. The downward trend in venture capital funding to various sectors may indeed be influenced by the broader economic environment shaped by prevailing low interest rates.

Firstly, when interest rates are low, the returns on traditional fixed-income investments, such as bonds, tend to be less attractive. As a result, investors, including hedge funds, may seek higher returns in riskier assets. However, low interest rates lead to reduced future cash flows due to a higher discount factor in these riskier assets. This quest for higher returns can lead to increased exposure to volatile markets and riskier investments, contributing to losses when market conditions become unfavorable.

Moreover, low interest rates can impact the profitability of financial institutions and affect the overall economic landscape. When interest rates are low, banks may face narrower interest rate margins, affecting their ability to generate income from lending activities. This, in turn, may result in reduced lending and capital available for businesses, potentially affecting the performance of companies across various sectors, including those funded by venture capital.

In the context of venture capital, the concern about reduced innovation and the potential lack of diversity in investment choices may arise from a climate where investors are cautious due to economic uncertainties linked to low interest rates. Investors may become more risk-averse, preferring to allocate funds to well-established companies or business models, such as those in the examples provided (Uber Eats, DoorDash, Grubhub), rather than exploring innovative but unproven ventures.

In summary, the losses in global hedge funds and reduced investment can be connected to the consequences of prolonged low interest rates, which impact investment decisions, risk appetite, and the overall financial health of various sectors, among other factors. This, in turn, can contribute to a reduction in venture capital funding and potential concerns about the diversity of innovation, particularly in unregulated industries.

Pros and Cons of a 'higher for longer' approach

The Contrarian Perspective on Lowering Interest Rates Sooner

On the other side of the debate, some argue that reducing interest rates may be in the best interest of the United States. Keeping interest rates higher for an extended period can potentially slow overall economic growth, primarily due to reduced borrowing, which discourages spending and investment. Although the job market demonstrated resilience during the pandemic, a reduction in consumer spending could impact employment rates. The average household savings, while reaching a peak of $3,074, have been eroded by rising prices and remain under pressure due to persistently high interest rates. This situation places a financial burden on average households and signals a potential economic decline. Furthermore, prolonged high interest rates could adversely affect the stock market, particularly technology stocks, as companies face increased borrowing costs, making it challenging to raise capital for growth. This, in turn, leads to lower valuations, potentially triggering market sell-offs and a shift towards higher-yield fixed income instruments.

Historically, there are instances where lowering interest rates has been employed as a tool to combat economic downturns. For example, during the 2008 financial crisis, the Federal Reserve, under the leadership of then-Chairman Ben Bernanke, implemented aggressive interest rate cuts to stabilize the economy and prevent a deeper recession. Similarly, during the COVID-19 pandemic, the Federal Reserve quickly lowered interest rates to near zero to provide economic support.

Additionally, lower interest rates can have positive effects on the housing market. Reduced interest rates make mortgages more affordable, encouraging homebuying and potentially boosting the construction industry. This can have positive spillover effects on related sectors and contribute to overall economic recovery.

However, there are concerns about the potential for creating bubbles in certain asset classes when interest rates are kept too low for an extended period. When borrowing costs are cheap, investors may engage in riskier behavior, chasing higher returns in asset markets. This search for yield can lead to inflated asset prices and the formation of bubbles such as the housing bubble in the mid-2000s, fueled in part by low interest rates, which eventually led to the 2008 financial crisis.

In summary, while lowering interest rates can be a tool to stimulate economic growth, it should be managed carefully to avoid the formation of speculative bubbles. Historical examples underscore the importance of a balanced approach, as excessively low interest rates can contribute to unsustainable asset valuations and subsequent market disruptions. Therefore, the Federal Reserve must carefully consider the potential risks and benefits of interest rate adjustments to achieve a delicate balance in supporting economic growth without inadvertently fostering speculative excesses.

Pros and Cons of lowering interest rates sooner

In conclusion, the Federal Reserve's decision to maintain higher-for-longer interest rates is a matter of debate, with differing viewpoints on how to address the issue of inflation and its broader economic implications. The path forward will require careful consideration of the potential benefits and drawbacks of this strategy in the context of the evolving economic landscape.