How a Fed rate hike could actually stimulate the U.S. economy

A colleague of LaVorgna’s, Deutsche Bank Chief Global Strategist Bankim Chadha, recently put forward the view that lower rates prompt households to save more, and therefore consumer spending is not an effective avenue for stimulus through traditional monetary policy actions.

So higher rates, to a certain point, could prove a boon for consumers. And the same is true for stocks, argues JPMorgan’s Kelly. His analysis shows that rising rates from a low level tend to be accompanied by rising stock prices, while hikes from higher levels typically happen in tandem with declines.

“When the Federal Reserve raises rates from low levels it is generally taken as a sign of economic confidence — that the economy no longer needs the Fed’s help — and that rising confidence is generally positive for stocks,” the economist wrote.

A rate hike that signaled increased confidence in the U.S.’s economic prospects could also shatter the conservative mentality that’s pervaded corporate America, providing the impetus for expectations and priorities to be reorganized.

“With the Fed promoting lower [rates] for longer, there has been a sense of complacency in the business community, more of a focus on financial engineering and balance sheet management vs. top-line growth,” says Jacob Oubina, senior economist at RBC Capital Markets. “There’s a dearth of focus on revenue-generating capital expenditures, which is the traditional way successful businesses have been run.”

The surge in corporate bond issuance, he notes, has been used primarily for share buybacks, mergers, and to drive bottom-line growth by reducing interest expenses. A hike could be just what’s needed to change businesses’ expectations, according to the economist.

A more pro-growth stance by businesses would likely entail capital deepening (an increase in capital equipment relative to the workers who operate it), Oubina added, which would further support top-line, productivity and economic growth.

“How good can the economy be if rates are still at zero?” quipped Deutsche Bank’s LaVorgna, agreeing that liftoff would have a positive psychological effect. “The Fed saying that the emergency is over and it’s time to begin the slow, gradual process of normalization would make businesses, investors, and households more confident in the outlook.”

And if the Fed wants to see a so-called Great Rotation from bonds into equities, which would presumably be a plus for stocks and spur a positive wealth effect, LaVorgna thinks the initiation of a hiking cycle is a prerequisite.

“This is something that happens when people think the economy’s doing better and the Fed’s raising rates,” he says. “When you’re not guaranteed to not lose money on your bond portfolio, that’s going to help push people into equities.”

There is, however, a large caveat that accompanies this argument that a rate hike would equal an increase in accommodation: the extent to which liftoff by the Federal Reserve might have negative effects outside the U.S. These effects could ricochet back to the world’s largest economy, potentially mitigating any of the stimulative effects cited by the trio. Although none of these economists identified an inflection point at which rate hikes would serve as a net headwind on growth, all agreed that the first hike surely wouldn’t be that moment.

“The medical profession has determined that two 4-ounce glasses of wine for a male adult is a healthy amount, not two bottles,” said LaVorgna. “We’re just talking about trying to renormalize an economy that’s effectively gotten used to zero rates.”