3 Ways a Premature Interest-Rate Hike Could Harm the Economy

Interest rate hikes and the economy

Perhaps the biggest question among investors today is when the Federal Reserve will raise interest rates.

Fed watchers say there are three realistic candidates for the date of the first rate hike in many years:

  • September 2015
  • December 2015
  • March 2016

But a Fed hike remains controversial. A premature interest-rate increase could hamstring in the U.S. economy just as it is starting to get a modest bit of momentum. This risk is particularly important right now, because the United States is one of the few major economies recording solid economic growth.

Rates are near zero, but cannot remain low forever. The timing of a rate increase draws a lot of conversation and debate among economists, investors and market commentators.

Some think the Fed should have raised rates already. Others think the time is right to raise rates now. And a few think we should wait quite a while before hiking rates.

In reality, it is impossible to know exactly when to raise rates. But what could happen if the Fed raises rates too soon? There are at least three significant potential consequences:

Related: 10 Ways Interest Rates Affect You Every Day

1. Businesses Pull Back, and a Recession Follows

Businesses could find that rising rates leaves them unable to handle the additional debt costs on their balance sheet. As a result, they could stop borrowing. Ultimately, this could lead the economy back into a recession. Companies know that the low-interest-rate environment won’t last forever, and many big firms have been adding to their debt levels while rates remain low and issuing bonds at a record-breaking pace. If the Fed starts to raise rates rapidly, all of that new issuance will evaporate overnight. The result would be that firms have less in the way of funds to invest in new projects, and less in the way of funds to buy back their own stock.

If firms stop issuing debt and investing in new equipment, new workers, and stock buybacks, it would lead to slowing demand across the economy. Business demand has been an important growth driver of late, with a 3.2 percent increase in business investment in the second quarter. The last thing the U.S. economy needs is slower growth, but that’s exactly what will happen if rates rise too fast and companies pull back on spending plans. The result could be a mild recession.

Investors looking to hedge this risk could consider some of the available inverse bond ETFs like the ProShares Short High Yield ETF trading under ticker SJB. Of course, these investments have risks, and can be volatile. So investors should check with a financial professional to make sure that any investment is right for them.

Read: How the Stock Market Can Help You Survive in Retirement

2. The U.S. Dollar Strengthens, Creating a Job Exodus

The U.S. dollar could strengthen too much, creating a manufacturing and job exodus. This could lead not only to a recession, but also to a further crippling of the U.S. economic base. If the Fed raises rates by 1 percent or more, it will create a strong incentive for people to take their money out of their own currency and invest it in the United States via dollars, which offer a higher rate of return on their investment.

This leads to a strengthening dollar exchange rate. A stronger U.S. dollar is a double-edged sword. It makes U.S. citizens wealthier in terms of their ability to buy more foreign goods and assets (e.g. imports), but it also makes exports and tourism to the United States more expensive for people in other countries.

The latter point is particularly problematic. If the dollar strengthens dramatically and chokes off exports, it will lead to an incentive for manufacturers to relocate to other countries where the currency is not as strong. This exodus of manufacturing would be very problematic for the economy in both the short and long term. It’s also why one of the first things the Chinese did to try and shore up their own slowing economy was to devalue their currency.

What can an investor do to avoid this risk? The easiest answer is to make sure you are invested in a basket of stocks from around the world, rather than just purchasing and holding U.S. stocks.

There are many low-cost ETFs that offer global exposure. If the dollar strengthens and hurts the U.S. economy, other economies should be helped, which in turn would lead to stronger stock markets in those nations.

Read: 10 Best Short-Term Stock Investments

3. The Stock Market Loses Its Luster and Collapses

The stock market could become less attractive compared to bonds that yield more after a rate increase. The shift in demand between asset classes could cause a stock market collapse, leading to a wealth drain that would hinder firms raising equity capital and crush the wealth of investors around the globe. This is a real risk, and one that even some members of the Fed think the market does not fully appreciate. This risk is perhaps the most likely disaster to occur.

In late August, investors got a taste of the type of volatility that could ensue once the Fed starts raising rates. But there could be more to come.

The global economy is fragile right now, and if investors decide the Fed is being too aggressive or that bonds are now a better alternative than stocks on a relative basis, the market could easily correct 10 percent to 20 percent.

The best hedge against this type of risk is a diversified portfolio of stocks, bonds and cash. Investors need to make sure they are comfortable with the possibility of severe volatility over the next year in any stocks they hold. A balanced portfolio will at least ensure that the investor is not relying solely on equities for an investment return.

So when will the Fed raise rates? It could be in September, December or March. But given the recent economic turmoil, the odds of a September liftoff have subsided a little in recent weeks. That’s probably a good thing as it should give the global economy at least a little more time to work through its myriad issues while avoiding some of the disasters outlined above.

No one wants the Fed to keep rates too low for too long, but at this stage, the risks are probably on the side of raising rates too early rather than too late.

About the Author

Michael McDonald is an assistant finance professor and consultant to companies regarding capital structure decisions and investments. He holds a PhD in finance and his research has been quoted in the Wall Street Journal and Bloomberg. He provides corporate consulting through Connecticut Expert Witness Consulting and teaches classes in the areas of corporate finance and investments.