Today’s the day when the Federal Reserve, America’s central bank, decides whether or not to raise interest rates.
The financial press are all over the story this week. The FT even gave over their homepage to “the decision” for the last couple of days.
Everyone has an opinion on it. So today, I want to step back from small cap investing to weigh in on the biggest issue in the markets.
I want to show you a graph Matt O’Brien of the Washington Post published earlier this week. I think it makes a better case against a rate hike than any of the two dozen opinion columns I’ve read about the subject lately.
The graph depicts interest rates in a few of the world’s biggest economies: the eurozone, Canada, Sweden, Israel and Japan. And as you can see, it shows a clear pattern.
In each of those countries, the central bank decided to hike interest rates only to cut them shortly afterwards. What happened?
Interest rates: first up, then down
The chart tells a very simple story. In each of the countries above, central banks raised rates before the economy was strong. When they raised rates, the economy weakened. And then the central bank was forced to cut rates once again, to resuscitate it.
The pattern usually goes something like this: the economy begins to show signs that it’s improving, for example the early signs of inflation in Japan in 2006. The central bank, in its zeal to fight inflation, raises interest rates. The economy tanks. And within a year or so, it’s forced to admit its mistake and cut interest rates to fix the problem. Sweden is just the latest victim of itchy-trigger-fingered central bankers.
Now obviously, this graph is a bit of a warning to the likes of Mark Carney at the Bank of England and Janet Yellen in Washington. Mis-timing a rate hike can be disastrous. Each of the little “peaks” in the graph above represent the country falling back into recession, with unemployment and market crashes and deflation and the rest of it. Not a good place to be.
But I think the graph also makes a deeper point about economics, central banking and investing.
The point is this: no central bank is truly in control of interest rates. Central banks manipulate short term interest rates to goose the economy – but only in the short run. In the long run, the health of the economy calls the shots.
A common argument is: “higher interest rates are a good thing, so therefore the central bank should raise interest rates”. But it doesn’t work like that.
Higher interest rates are normally a good thing. But higher interest rates are a consequence of a fully employed economy which is generating lots of profitable investment opportunities.
Central bankers can’t “cut corners” and just mandate higher interest rates, when the economy isn’t strong. The chart above shows why happens when they try.
What does it mean for investors? It means you should be wary of the line that central bankers are responsible for low returns. Central bankers don’t call the tune – the health of the economy does.
Watch output growth, wage growth, unemployment. That’s a better indicator of how much money the markets will return than than the machinations of Janet Yellen or Mark Carney.