The Economy: Why Interest Rates Shouldn't Rise Anytime Soon

This is the first in a three-part series on the economy, earnings and equities.

Real is irrelevant.

The US Federal Reserve (the Fed) is unconcerned about real GDP — the inflation-adjusted measurement of US economic growth. Rather, without inflation in our economy, the Fed is focused on raising nominal GDP. And that priority means that interest rates should stay low for the foreseeable future.

To gain a bit of perspective on interest rates, it’s helpful to take a look at the Taylor Rule. Named for Stanford economist John Taylor, the Taylor Rule was introduced as a methodology for controlling interest rates in a way that would promote short-term stability and long-term growth. While the Fed has not officially adopted this methodology, its policy decisions have historically kept interest rates in sync with the rule — until the economy plunged in 2009, that is.

At that point, the Taylor Rule suggested that interest rates should fall into negative territory. However, the Fed kept the federal funds rate at zero. Today, the Taylor Rule suggests that due to quantitative easing (QE), the federal funds rate should be well within positive territory, and moving close to the 6% mark by 2016.

That’s not the path that the Fed is on, however. To understand the Fed’s priorities, we look to another economist, Janet Yellen. Yellen is the vice chair of the Fed’s Board of Governors, and the frontrunner to replace current Fed Chairman Ben Bernanke when his term expires on Jan. 31, 2014. Yellen is instrumental in constructing the Fed’s econometric models, and her perspective is that the nominal GDP gap — the gap between actual GDP and potential GDP — is the most significant issue facing the Fed today. In Yellen’s view, nominal GDP will need to grow close to 6% for several quarters to close that gap and bring unemployment back in line with the Fed target of under 6.5% (versus 7.6% in March).

With today’s nominal GDP growth at 3.7%, the Fed has a clear path to try to stimulate nominal GDP growth through low interest rates. I do not believe we are in any jeopardy of entering a rising interest rate environment as long as inflation can be kept under control. While the Fed may stop purchasing Treasuries and mortgages, I believe we’re in a zero federal funds rate environment for years to come.

If you’re running a business, this is critical. With the Fed maintaining a low-rate environment, business owners can turn their concerns away from the macro environment and toward their business — building the products that people will buy and focusing on the factors that they can control. That is an exciting proposition for US businesses and people who invest in them. If the Fed can achieve 6% nominal GDP growth and higher, that would be very positive for revenue growth and would promote a great environment for equity investors.

This wouldn’t happen overnight, though. Stay tuned for my next two blog posts, which will explore the need for business reinvestment and my outlook for equities.

Important Information

Interest rate risk refers to fluctuations in the value of a fixed-income security resulting from changes in the general level of interest rates.

Invesco Distributors, Inc.

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