Will Further Rate Hikes Crush the Economy?

Dan Shainberg
November 2, 2018

Rising rates can be a sign of a strong economy if they are rising due to inflationary pressures, or a weak economy if they are rising because of a change to the supply and demand of credit. When the economy is flush with cash, lending activity increases, and investors scramble into deals where traditional credit risk metrics may be ignored. When the economic outlook sours, the relative demand for capital increases while the supply demands higher risk premiums, the combined effect of which is an increase in overall rates and/or spreads. 

There is almost universal agreement today, with unemployment at record lows and wage inflation soaring, that the rising rate environment is due to a strong economy. The Fed is increasing rates and credit spreads remain extremely tight. But if the Fed artificially raises rates, will the collapse the economy? Or is it simply going to serve as a GDP headwind, allowing for continued softer growth rates while reigning in the associated undesirable inflationary impacts?

“Further rate hikes will spark next stock market crash”, Peter Schiff warns, but without much substance. The perma-bear is probably right, but why? Why is he so convinced that rising rates will turn the economy into the Great Depression instead of triggering a soft landing where inflation and growth rates rest in a healthy balance?

The key culprits for financial crises is leverage. The last crisis in 2008 was primarily ignited in the banking sector, although the government certainly held a heap of blame. Today, the banking sector is much more regulated and healthy, although the shadow-banking sector is always a risk given more limited oversight. But the central banking and corporate sector debt is inflated. There is no doubt that should a similar ignition be lit in either of these sectors, the contagion could very well grow to be materially worse to the economy than that of the recession from a decade ago. In the next crises, there won’t be a central bank band-aid like we saw in the aftermath of the Great Recession.

We don’t know what will cause the ignition for the next financial crises, but a betting person would have to seriously consider that the next big one could be started by the likelihood for runaway inflation over the next 1-2 fiscal quarters. We are already seeing signs from Q3 2018 that the Fed’s 2% target for the CPI materially discounts true inflation which can be 3x greater when you actually read the statements from corporate America. As inflation whips up, interest rates will have to rise, and if they risk into a spike, which is likely, the “soft-landing” will not happen.

Dan Shainberg

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