Why Low Interest Rates May Be Good For Financial Stability

Many pundits argue that low interest rates are sowing the seeds of another financial crisis. However, the historic evidence suggests that excessive financial deregulation, rather than lower interest rates, has been the primary cause of financial crises. In fact, easy monetary policy - to the extent that it leads to higher inflation and ultimately, to higher nominal interest rates - can actually enhance financial stability.

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Our report recommends analyses how to remain tactically short U.S. equities: A looming Fed rate hike, weak earnings growth, and the prospect of a Trump victory will all weigh on stocks over the coming weeks. Below are some of the insights contained in this publication:

Fedspeak Continues To Rattle Markets

The "will they or won't they?" debate continues to batter risk assets. Last Friday, Boston Fed President Eric Rosengren backed an interest rate hike this year. What makes Rosengren's remarks special is that he has a reputation for being an unwavering dove.

The market does not particularly care what hawkish members of the FOMC have to say. Hawks squawk. That's what they do. But when someone like Rosengren decides it is time to raise rates, investors should take notice.

Governor Lael Brainard's speech on Monday arguing in favor of a "go slow" approach to raising rates gave equities a short-lived bounce. However, the damage appears to have been done. The 10-year Treasury yield currently stands at 1.70%, just shy of its three-month high of 1.75% reached earlier this week. Expectations of a rate hike this year have also moved up to 45% (Chart 1).

Why are so many members of the FOMC keen to raise rates? In part, it is because they think that the U.S. economy will stay strong enough to absorb whatever excess capacity still remains. Granted, real GDP grew by only 1.1% in Q2. However, inventories shaved 1.3% from growth. Real final sales, which strips out the contribution from inventory fluctuations, expanded by 2.4%, with personal consumption rising by a healthy 2.9%.

The Atlanta Fed's GDPNow model points to growth of 3% in Q3, while the New York Fed's Nowcast stands at 2.8% - easily above most estimates of trend growth. The risk is that neglecting to raise rates now could force the Fed to tighten too quickly in the future. As Rosengren said, "delays in tightening earlier in the cycle could lead to conditions that require more rapid increases in interest rates later in the cycle."

Chart 1

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