The Fed Raises Interest Rates: What Could Go Wrong
Business + Economy

The Fed Raises Interest Rates: What Could Go Wrong

The grand experiment started exactly seven years ago, at a time when the economy was in the depths of recession and the financial world looked like it could crumble. On Dec. 16, 2008, three months after Lehman Brothers filed for bankruptcy, the Fed slashed its rate on overnight loans to banks to between 0 and 0.25 percent — the first time it had dropped the rate below 1 percent.

“The Federal Reserve will employ all available tools to promote the resumption of sustainable economic growth and to preserve price stability,” the official statement from the Federal Open Market Committee said at the time. “In particular, the Committee anticipates that weak economic conditions are likely to warrant exceptionally low levels of the federal funds rate for some time.”

Related: The 3 Biggest Winners from the Fed’s Rate Hike​​​​​

“For some time” was right. As in indication of just how long it’s been, consider this, from Peter Boockvar, chief market analyst at the Lindsey Group:

“The last time the Fed embarked on a rate hike cycle in June 2004, Hoobastank’s song ‘The Reason’ was #1 on Billboard’s chart. ‘Harry Potter and the Prisoner of Azkaban’ premiered in the theaters. ‘The Sopranos’ was more than halfway through its run and ‘Friends’ ran its final episode. The Detroit Pistons won the NBA championship that month with Chauncey Billups as the MVP. Ronald Reagan passed away. Ken Jennings also started his 74-game winning streak on the game show ‘Jeopardy!’”

Now, after seven years — and after buying trillions of dollars’ worth of bonds and mortgage-backed securities to help stimulate the economy and support the housing market — the Fed has finally decided it’s time for those “exceptionally low” interest rates to rise. The era of easy money stimulus is over.

Except that it’s not.

Rates remain at historically low levels and Fed officials have emphasized that they will keep rates below where they might normally be for an extended period of time. They did so again in their statement Wednesday. “The Committee expects that economic conditions will evolve in a manner that will warrant only gradual increases in the federal funds rate; the federal funds rate is likely to remain, for some time, below levels that are expected to prevail in the longer run,” the statement said.

Related: What’s the Fed Rate Hike Means for Your Money

Fed officials’ new forecasts for interest rates at the end of 2016 stayed at 1.4 percent, the same as they were in September, implying four more quarter-point increases next year — but the median estimate for 2017 dropped to 2.4 percent from 2.6 percent and the outlook for 2018 fell to 3.3 percent from 3.4 percent.

That path forward may not be as smooth as the projections suggest.

“In our view, the risk that things go wrong is greater than things going well,” BNP Paribas economists noted yesterday. They see only a 30-percent chance that the Fed “pulls off the perfect tightening cycle,” one in which economic growth steadily accelerates without a spike in inflation above the Fed’s targeted 2-percent annual rate.

One and Done?
The BNP team ascribes higher odds, 45 percent, to a “swing and a miss” scenario, in which the economy either struggles, leaving the Fed no room to continue raising rates, or inflation rises, forcing the central bankers to hike rates faster than they’ve signaled. And the economists place 25-percent odds on a “run for the hills” scenario, in which the economy slumps even as inflation rises.

Related: 10 Things That Will Cost More in 2016

“We see the risks to the outlook as tilted toward a near-term hiccup, which forces the Fed to pause its normalization plans or perhaps even reverse course,” they wrote.

Boockvar sounded a similar note: “I still think we’ve just seen the only rate hike we’ll get in this recovery and the next one won’t come until during the expansion after the next recession.”

“The last time the Fed stuck to a promise to take it easy — the ‘measured’ pace of tightening in 2004-to-06, it ended badly,” Ian Shepherdson, chief economist at Pantheon Macroeconomics, wrote to clients, “and we have no confidence that the serene glide path for the economy envisaged by the Fed and, especially, the markets, will be achieved this time either.”

If or when the economy does swing back into recession, the downturn might still signal how far we’ve come since 2008. “This tightening, like that one, will end in recession eventually,” Shepherdson wrote this week, “but this time around we expect a garden-variety business cycle downturn rather than a massive financial crash and a near-death experience for global capitalism. Extraordinary meltdowns require extraordinary economic imbalances, but the finances of banks, businesses and households are all now in much better shape than in 2007, when the strains in the markets leading to the crash of 2008 first began to appear.”

After seven years, that counts as progress.