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Avoiding the stagnation equilibrium

How raising rates from a low level can boost economic growth

IN B RIE F
It is commonly assumed that when the Federal Reserve (Fed) begins to raise short-term interest rates from near-zero levels,
their actions will slow the economy.
We believe this is wrong, that the relationship between short-term interest rates and aggregate demand is non-linear,
and that the first few rate hikes would actually boost aggregate demand, although further hikes from a higher level could
reduce it.
To show this, we look at six broad effects of raising short-term interest rates: An income effect, a price effect, a wealth
effect, an exchange rate effect, an expectations effect and a confidence effect.
This analysis suggests that the Fed should, belatedly, begin to raise rates now, not because the economy is strong enough
to take the hit, but rather because it is weak enough to welcome the help.

AVOIDING THE STAGNATION EQUILIBRIUM

AUTHORS
Dr. David Kelly is the Chief Global Strategist and Head of the Global Market Insights Strategy Team.
With over 20 years of experience, David provides valuable insight and perspective on the economy
and markets to thousands of financial advisors and their clients.
Throughout his career, David has developed a unique ability to explain complex economic and
market issues in a language that financial advisors can use to communicate to their clients. He is a
keynote speaker at many national investment conferences. David is also a frequent guest on CNBC,
and other financial news outlets and is widely quoted in the financial press.

Dr. David P. Kelly, CFA

Managing Director
Chief Global Strategist

Prior to joining J.P. Morgan, David served as Economic Advisor to Putnam Investments. He has also
served as a senior strategist/economist at SPP Investment Management, Primark Decision
Economics, Lehman Brothers and DRI/McGraw-Hill.
David is a CFA charterholder. He also has an Ph.D and M.A. in Economics from Michigan State
University and a B.A. in Economics from University College Dublin in the Republic of Ireland.

Ainsley E. Woolridge, Analyst, works on the Global Market Insights Strategy Team led by David
Kelly. She, along with the team, is responsible for publications such as the quarterly Guide to the
Markets and performing research on the global economy and capital markets.
Ainsley joined the firm in 2013, after graduating from Penn State University with a Bachelors
degree in finance, a concentration in accounting and a minor in international business.

Ainsley E. Woolridge
Market Analyst
New York

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AVOIDING THE STAGNATION EQUILIBRIUM

INTRODUCTION
At their September meeting, the Federal Reserve decided, for
the 54th consecutive time, to leave short-term interest rates
unchanged at a near-zero level. While only one voting member
of the Federal Open Market Committee (FOMC) dissented, the
Feds action, or rather inaction, was hotly debated.
Those advocating an immediate hike argued that the economy
had progressed far beyond the emergency conditions that had
led to the imposition of a zero interest rate policy in the first
place and that the Fed was already dangerously behind the
curve. Those lobbying for further delay pointed to a lack of
wage inflation and signs of weakness in the global economy.
However, frustratingly, we believe this argument, like all
monetary policy debates in recent years, has been waged on a
false premise, namely that increasing short-term interest rates,
even from these extraordinarily low levels, would hurt
aggregate demand. We believe that the opposite is true. The
real-world relationship between interest rates and aggregate
demand is non-linear and an examination of the transmission
mechanisms suggest that the first few rate hikes, far from
depressing aggregate demand, would actually boost it.
Raising short-term rates from near zero should boost
economic demand, although raising rates from higher
levels could reduce it
EXHIBIT 1: NON-LINEAR RELATIONSHIP BETWEEN SHORT-TERM
INTEREST RATES AND OUTPUT

The true relationship may, in fact, be as portrayed in Exhibit 1.

As we outline in the pages that follow, raising short-term
interest rates from very low levels could actually increase
aggregate demand as positive income, wealth, expectations and
confidence effects outweigh relatively innocuous negative price
effects and ambiguous exchange rate effects. However, as
interest rates increase further, the price effects of rate
increases become more damaging while wealth, expectations
and confidence effects eventually turn negative, causing rate
increases to drag on economic demand. In other words,
monetary tightening from super-easy levels can actually
accelerate the economy beyond its potential growth rate before
slowing it, ideally to a soft landing at a higher level of output
and interest rates.
There is, of course, more to the story. All of these effects have
changed over the decades so that this argument might not have
been as strong had a zero interest rate policy been employed,
say, in the 1960s. In addition, the impact of interest rates on
the economy is asymmetric a cut in interest rates from a
normal level that had been sustained for some time might well
boost demand even if an increase to that level didnt dampen it.
Finally, on the supply side, there is likely a significant long-term
cost in lost economic efficiency from holding the price of
money at an artificially low level. All of these issues are worth
further research. However, for the Federal Reserve, the basic
point is the most important one. The reason it should have
raised rates in September and the reason, failing that, that it
should do so in October isnt that the economy can handle the
pain but rather that it could do with the help.

LOOKING AT TRANSMISSION MECHANISMS

Source: J.P. Morgan Asset Management. Data are as of October 13, 2015. The chart
above and the charts, graphs and tables herein are for illustrative purposes only.

There are basically two ways to evaluate the impact of changes

in short-term interest rates on the economy. One approach is to
use a large-scale econometric model in which short-term
interest rates are included as independent variables, impacting
the economy through a variety of time series equations. Such
models are always plagued by problems of misspecification,
measurement error and reverse causality. However, in this case,
the biggest problem probably relates to the time frame over
which the equations are estimated. Put simply, if the
relationship between short-term interest rates and aggregate
demand varies significantly depending on the level of interest
rates and the model is estimated over a period of time in which

J.P. MORGAN ASSE T MA N A G E ME N T

AVOIDING THE STAGNATION EQUILIBRIUM

interest rates are relatively normal, the model cannot be

trusted to provide accurate answers when interest rates are
very far from normal.
An alternative approach is to open the hood and take a look
at the ways in which short-term interest rates should actually
impact the economy. While there may be other minor effects,
the following six transmission mechanisms should capture most
of the important relationships:
T he income effect: Higher interest rates increase the
interest income of savers while increasing the interest
expenses of borrowers. In the household sector, in
particular, short-term, interest-bearing assets are far larger
than variable rate interest-bearing liabilities so that
increasing short-term interest rates should boost income
and thus aggregate demand.
T he price effect: Higher interest rates make it more
rewarding to save and more expensive to borrow. In theory,
raising interest rates will encourage households to save
rather than consume and cause some businesses to forgo
investment projects because they are unlikely to generate
the cash flow to justify the higher interest cost. Higher rates
could also reduce the number of families that qualify for
home mortgages, thus slowing the housing market. All of
these effects should reduce demand in the economy.

The wealth effect: The value of an asset is generally
determined by the discounted value of future cash flows
that that asset will produce. Higher interest rates increase
the discount rate in these calculations and thus could reduce
wealth and thereby consumption through a negative
wealth effect.

The exchange rate effect: Short-term capital flows are
important in determining exchange rates. In theory,
currency traders like to park their money in currencies with
higher overnight interest rates. In this way, higher interest
rates could increase the demand for dollars, thereby
boosting the exchange rate and, by doing so, suppress
exports and slow the economy.

The expectations effect: When a central bank begins to
raise rates and signals an intention to gradually increase
them further, households and businesses may try to borrow
ahead of further rate hikes, boosting both consumption and
investment.

T he confidence effect: When a central bank raises rates

from a low level, it is generally interpreted as an expression
of confidence in the economy that may prompt consumers
and businesses to spend more. By contrast, when they raise
rates from a high level, it may well be seen as fighting
against an inflation problem and the private sector may cut
back its spending in anticipation of weaker growth ahead.

The income effect: A powerful positive for

aggregate demand
So much for basic economic theory how would these effects
actually operate in the American economy of 2015?
In the case of the income effect, rising rates should be a
powerful stimulus. As can be seen in Exhibit 2, the American
household sector has levered up in recent decades with both
interest-bearing assets and interest-bearing liabilities
increasing steadily relative to GDP. However, importantly, most
of the growth in interest-bearing assets has come in the form
of relatively short-term instruments such as CDs, money
market funds, short-term bonds and interest-bearing deposit
accounts. The growth in liabilities, by contrast, has been
focused in long-term liabilities. In particular, more than 90%
of mortgages issued in recent years have been fixed rate
mortgages. Even other consumer debt is largely fixed rate
student loans are overwhelmingly fixed rate and auto loans,
although currently lasting an average of just 65 months, are
generally fixed rate as well.
Raising interest rates should be a big net positive for
household income
EXHIBIT 2: INTEREST-BEARING ASSETS AND INTEREST-BEARING
LIABILITIES AS A PERCENT OF GDP
100%
90%
80%
70%

Interest bearing assets

60%
50%
40%

Liabilities

30%
20%
10%

Liabilities ex. home mortgages

0%
45 49 53 57 61 65 69 73 77 81 85 89 93 97 01 05 09 13

Source: BEA, FRB, J.P. Morgan Asset Management. Data are as of October 13, 2015.

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To see the immediate effect of an increase in short-term

interest rates, we start with the financial assets and liabilities
of the household and non-profit sector from the Financial
Accounts of the United States for the second quarter and
estimate the fraction of both1 assets and liabilities for which
interest rates adjust within a year. Largely because of the
dominance of fixed rate mortgages in household liabilities, we
estimate that, in 2Q 2015, $9.1 trillion in assets but only $2.5
trillion in liabilities carried interest rates that would adjust
within a year. Thus, in rough terms, a 1% increase in short-term
interest rates could be expected to increase household interest
income by $66 billion within a year (that is 1% x ($9.1T $2.5T),
or 0.4% of personal income.2

The price effect: Not a huge deal at super-low

rates
In theory, rational consumers should react to higher interest
rates by saving more and borrowing less. However, as is shown
in Exhibit 3, the personal savings rate actually appears to be
inversely related to interest rates. To a large extent, of course,
this reflects the fact that falling interest rates usually coincide
with a weak economy when households may feel it is more
prudent to spend less. However, another reason may be the
well-known investor aversion to selling principal. As yields have
fallen, those who want to maintain a higher income stream
may have stock-piled income-bearing assets.
More significantly, it is frequently argued that raising shortterm interest rates will sink the housing market. This might be
true at much higher rates but not at todays superlow rates.
The key to seeing this is to recognize that potential homebuyers essentially need to overcome three hurdles to qualify
for a mortgage. They need to be able to accumulate a down
payment, achieve an acceptable credit score and prove that
they can make the monthly payment.

Rising rates havent boosted the savings rate in the past

EXHIBIT 3: FEDERAL FUNDS RATE AND 6-MONTH MOVING AVERAGE
PERSONAL SAVINGS RATE
12%
10%

Correlation: -0.01

8%

Personal savings rate

6%
4%
Federal funds rate

2%
0%
88

91

94

97

00

03

06

09

12

15

Source: BEA, FRB, J.P. Morgan Asset Management. Data are as of October 13, 2015.

However, as is shown in Exhibits 4, 5 and 6, making the

monthly payment is, at this time, by far the easiest of those
hurdles to surmount. Credit scores for approved mortgages
remain extremely high, reflecting a much tighter regulatory
environment and a perceived lack of profitability on long-term
fixed rate mortgages3, while down payments, even assuming
constant loan-to-value ratios, are well above average levels
relative to income. Monthly principal and interest mortgage
payments, by contrast, are well below average levels, with an
average 30-year fixed rate mortgage rate hovering below
4.0%. Because of this, mortgage payments are generally not a
binding constraint on home purchases increasing them by
0.5% or 1.0% from current levels would not generally crowd
out many home buyers who could meet the other two criteria.
This would, of course, be a different matter if mortgage rates
were at 6% or 7% to start with.

Assets with assumed duration less than one year are: Money market mutual funds, private foreign deposits, time and savings deposits, and 11% of Treasury securities.
Liabilities with assumed duration less than one year are: Trade payables, 18% of mortgages, 8% of auto loans, 8% of student loans, and 36% of personal and credit card
loans. Home, auto and credit card loan assumptions are based on the sensitivity of applicable interest rates to changes in short term rates. Student loan assumption is the
gross amount of student loan issued in the latest year as a percent of total outstanding student loans.
1

This powerful income effect is driven by the fact that American households have more financial assets than financial liabilities and their liabilities are of longer duration than
their assets. Of course, this implies that other sectors of the economy must be net borrowers and have a duration mismatch in the opposite direction. In particular, businesses
and the government tend to be net borrowers and the Federal Reserves liabilities are of far shorter duration than its assets. However, most corporate debt is of fairly long
duration and corporations are currently holding record cash balances themselves, so net business interest costs would only likely rise slowly in response to rate hikes. In
addition, the federal government is unlikely to curtail its spending either because of smaller remittances from a less profitable Federal Reserve or higher interest costs on the
new debt it issues. Consequently, we believe almost all the important income effects are concentrated in the household sector.
2

Apart from regulatory concerns, the Federal Reserves huge purchases of mortgage securities may be impeding mortgage supply by holding mortgage rates at artificially low
levels. If banks believe the Feds current projection that the long-run average level for the federal funds rate will be 3.5% and if long-term mortgages continue to be funded
by short-term money, it is hard to see any long-term profitability in issuing mortgages at their current 30-year fixed rate mortgage rates of less than 4%.
3

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Monthly mortgage payments are well below average levels

EXHIBIT 4: AVERAGE MORTGAGE PAYMENT AS A % OF HOUSEHOLD
INCOME
40%
35%
30%
25%

Similarly, although much harder to analyze, on the corporate

side, there are probably very few projects that would be
abandoned due to an increase in interest rates from current
levels. When interest rates are this low, it is likely that the
binding constraints on business investment spending are views
on the growth in markets, taxation and regulation, rather than
the cost of financing.

The wealth effect: Non-linearity in the real world

20%

Average: 19.6%

Aug. 2015:
12.4%

15%
10%
75

78

81

84

87

90

93

96

99

02

05

08

11

14

Down payments are well above average levels

EXHIBIT 5: DOWN PAYMENT AS A % OF HOUSEHOLD INCOME
65%
Aug. 2015:
54.4%

60%

55%

In theory, higher interest rates should reduce asset values by

increasing the discount rate applied to their cash flows. In
practice, it is a little more complicated. In Exhibit 7, we show
the correlation between weekly movements in short-term
interest rates and the stock market over the past 50 years.
What is clear is that interest rate increases from low levels
tend to be associated with increases in stock prices while
increases in interest rates from higher levels tend to be
associated with declines in stock prices.
Increasing rates from low levels is associated with rising
stock prices

Average: 53.0%

EXHIBIT 7: CORRELATIONS BETWEEN WEEKLY STOCK RETURNS AND

INTEREST RATE MOVEMENTS

50%

0.4
0.3

45%

78

81

84

87

90

93

96

99

02

05

08

11

14

Credit scores for approved mortgages remain extremely high

EXHIBIT 6: AVERAGE FICO SCORE BASED ON ORIGINATION DATE

0.1
0
-0.1
-0.2
-0.3

760
July 2015:
745

-0.4
-0.5
0%

740

2%

4%

6%

8%

10%

12%

14%

16%

3-MONTH TREASURY YIELD

Source: FactSet, Standard & Poors, U.S. Treasury, J.P. Morgan Asset Management.
Returns are based on price index only and do not include dividends. Markers
represent monthly 2-year correlations only. Data are as of October 13, 2015.

720

700

680
04

05

06

07

08

09

10

11

12

13

14

15

Sources: Census Bureau, Federal Reserve,McDash, J.P. Morgan Securitized Product

Research, J.P. Morgan Asset Management.Monthly mortgage payment assumes
the prevailing 30-year fixed-rate mortgage rates and average new home prices
excluding a 20% down payment. Down payment assumes 20% of home purchase
price paid upfront. Data are as of October 13, 2015.

CORRELATION COEFFICIENT

40%
75

0.2

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Why is this? There are probably two basic reasons. First, 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 Feds help and that rising confidence is
generally positive for stocks. When, by contrast, the Fed raises
rates from higher levels, it is a sign that it is fighting a battle
against inflation and is trying to slow the economy down,
neither of which is a particularly positive message for stocks.
In addition, in recent decades, the Federal Reserve has openly
and deliberately pursued a policy of gradual changes in
interest rates both when raising them and when lowering
them. Consequently, as bond market investors get burned by a
first few rate increases, they suspect, rightly, that there are
more to come and therefore shift assets away from bonds and
toward stocks. At higher levels of interest rates, fears of
further rate increases should diminish, reducing these flows.
Thus, while the later stages of a rate-hike cycle could induce a
negative wealth effect through the stock market, the early
stages, based on history, should produce a positive one.
Of course, while increasing interest rates from a low level may
be associated with rising stock prices, households would see a
loss in wealth from falling bond prices. However, again in the
real world, market declines in the bond market are so much
milder than in the stock market that the initial few increases in
rates from super-low levels still likely boost financial asset
values overall. This is particularly the case if, as is widely
expected, long-term interest rates rise less than short-term
rates as the Fed begins to tighten.

The exchange rate effect: Buy the rumor, sell

the fact
In theory, the value of the U.S. dollar could rise as the Federal
Reserve raises its policy rate. Short-term rates help determine
a countrys foreign exchange because, all things equal, global
currency traders park their money overnight in currencies with
higher overnight interest rates. Buying an asset denominated
in a foreign currency requires first buying that currency, so
higher interest rates in the U.S. should theoretically create
higher demand for the U.S. dollar. A strengthening U.S. dollar
naturally beats down inflation and can drag on economic
growth.

The U.S. dollar has not increased in reaction to the start of

that last three rate hiking cycles
EXHIBIT 8: VALUE OF THE U.S. DOLLAR: INDEXED TO 100 IN THE MONTH
OF FIRST RATE HIKE
109
107
105

1988

103

1983

101

1999

99

1994

97
95
93

2004
-6

-5

-4

-3

-2

-1

MONTH

Source: FRB, J.P. Morgan Asset Management. Month zero for each cycle was May
1983, March 1988, February 1994, June 1999 and June 2004. Data are as of October
13, 2015.

In practice, however, the U.S. dollar has not increased in

reaction to the start of the last three rate hiking cycles. As
shown in Exhibit 8, when the Fed began to tighten in 1994,
1999 and 2004, the dollar strengthened in the six months
before the first rate hike and weakened in its aftermath.
Foreign exchange trading is an incredibly large market with
over $5 trillion in daily transactions according to the Bank for
International Settlements. The frequency of trading and
resulting efficiency of the market means that appreciation
caused by rate increases is priced in long before the actual
event. In fact, Exhibit 8 shows that in recent rate hiking cycles
the dollar exhibited buy the rumor, sell the fact behavior.
This wasnt the case in 1983 or 1989. However, given that the
U.S. dollar has appreciated by more than 13% over the past
year against the currencies of our major trading partners, and
the U.S. is now running a large and growing trade deficit, the
dollar seems just as likely to fall as it is to rise in the aftermath
of a first rate hike.

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The expectations effect: Borrowing ahead of

higher rates
In recent decades, the Federal Reserve has followed a policy of
moving interest rates in small increments while clearly
signaling that further rate changes are planned in the same
direction. While clear guidance on what the Fed intends is
probably a positive for economic efficiency, this strategy
actually undermines the very stimulus or drag that the Fed is
trying to impart. If the Fed succeeds in lowering mortgage
rates, it is cheaper to borrow money to buy a house. However,
if the Fed succeeds in lowering mortgage rates and promises a
further potential cut in another six weeks, a rational borrower
may want to see how low rates might go before acting.
Conversely, if the Federal Reserve raises short-term interest
rates but then promises to raise them further in the months to
come, someone who wanted to buy a house would have every
incentive to do so now before rates rose further. Today, there is
huge uncertainty about when the Fed might raise rates and the

pace of rate increases thereafter. However, once it begins to

raise rates, it will be a clear signal to borrowers (and homesellers for that matter) that it is best to get going now before
rates rise further.
Interestingly, this is also an effect that is much more powerful
with the first few rate hikes than the last few. The expectations
hypothesis of the term structure of interest rates espouses that
long-term rates depend on expectations of future short-term
interest rates. A steeper yield curve implies that market
participants anticipate increasing rates. As shown in Exhibit 9,
on the first day of each of the last five rate-hiking cycles, the
term structure of interest rates curved healthily upward.
However, the yield curve had risen and flattened substantially
by the end of the cycle in each instance. By the end of a rate
hiking cycle when the yield curve is much flatter, many
borrowers may feel that they have missed their opportunity to
borrow cheap this time around and might as well wait until the
Fed feels compelled to lower rates again5.

The yield curve has historically risen and then flattened by the end of the rate-hiking cycle
EXHIBIT 9: 3-MONTH T-BILL TO 10-YEAR TREASURY BOND ON THE DAYS OF THE FIRST AND LAST RATE INCREASES OF A HIKING CYCLE
May 1983 August 1984
14.0%

March 1988 February 1989

10.0%

Aug. 31, 1984

February 1994 March 1995

8.0%

Feb. 24, 1989

12.0%

Feb. 1, 1995

8.0%

6.0%

Mar. 24, 1988

Feb. 4, 1994

May 24, 1983

June 1999 June 2000

8.0%

June 2004 July 2006

6.0%

May 16, 2000

Jun. 30, 2006
6.0%

4.0%

Jun. 30, 2004

Jun. 30, 1999

Source: FactSet, J.P. Morgan Asset Management. Data are as of October 13, 2015.
While this is easiest to see in the case of home buyers, exactly the same effects should occur in the business sector.

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10y

7y

5y

2y

3y

0.0%

1y

Jun. 30, 2004: 3.29%

Jun. 30, 2006: 0.14%

3m

10-year 3-month

Jun. 30, 1999: 1.03%

May 16, 2000: 0.23%

10y

10-year 3-month

7y

5y

2y

3y

1y

2.0%

2.0%

3m

4.0%

7y

5y

3y

1y

2y

2.0%

3m

10y

7y

5y

2y

3y

4.0%

1y

10-year 3-month
Feb. 4, 1994: 2.64%
Feb. 1, 1995: 1.59%

3m

10-year 3-month
Mar. 24, 1988: 2.55%
Feb. 24, 1989: 0.42%

10y

10-year 3-month

10y

4.0%

May 24, 1983: 1.76%

Aug. 31, 1984 1.73%

7y

5y

3y

1y

2y

8.0%

6.0%

3m

10.0%

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The confidence effect: What does the Fed know

that we dont?
Nothing is more important to the health of a free-enterprise
economy than confidence. Confident consumers and
businesses, at the margin, spend a little more, hire a little
more and invest a little more. If this causes demand to exceed
supply in the economy even by a small amount, it helps the
economy grow. Because of this, one of the biggest drawbacks
of the Feds aggressively easy monetary policy in recent years
has been its negative impact on sentiment. On each occasion
when the Fed announced a new quantitative easing strategy,
hesitated to taper bond purchases or postponed a movement
from zero interest rates, it undermined confidence. The typical
question has been: What bad thing does the Fed know that
we dont?
Conversely, when the Fed raises rates from very low levels, it
generally acts to boost confidence. The table below shows
consumer confidence in the 12 months following the first rate
increase in each of the past five rate-increasing cycles. In each
instance, confidence increased as consumers reported feeling
positive about business, employment and income conditions.
By contrast, at the end of tightening cycles, when rates were
higher and the Fed was fighting a perceived inflation threat,
confidence appears to have been negatively impacted by the
Feds tightening.
Rate increases from very low levels generally acts to
boost confidence
EXHIBIT 10 : CHANGE IN CONSUMER CONFIDENCE INDEX 12 MONTHS
AFTER THE FIRST AND LAST RATE INCREASES OF A CYCLE

Rate increasing cycle

12-month change following:

First
Last
increase
increase

May 1983 - August 1984

19.5%

-2.1%

March 1988 - February 1989

4.2%

-11.6%

February 1994 - March 1995

24.4%

-1.4%

June 1999 - June 2000

0.1%

-19.8%

June 2004 - July 2006

3.3%

-0.1%

Source: FRB, Conference Board, J.P. Morgan Asset Management. Data are as of
October 13, 2015.

In other words, the relationship between interest rate increases

and consumer confidence changes as rates rise. Increasing
rising rates from low levels lead to positive movements in
sentiment, while raising rates from high levels has a negative
effect.

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There are, of course, many other problems with a zero interest
rate policy. It may, over time, lead to growth in both debt and
asset prices that exacerbate inequality in the short run and can
end badly when rates return to more normal levels. More
fundamentally, interest rates play a crucial role in the
allocation of resources in the economy. Artificially low interest
rates lead to credit being assigned inappropriately, whether,
for example, through the application of unreasonably tough
lending standards on small business loans and or unreasonably
easy ones on student loans.
However, the most urgent point is simply that, right now, the
economy could do with a little more demand. We believe that
the positive impacts of income, wealth, confidence and
expectations effects are only slightly offset by negative price
effects and thus the first few rate increases would actually
boost demand.
It is immensely disheartening that, in 2015, this point is not
only not generally accepted but has to be argued on each
occasion. Federal Reserve officials ponder the effectiveness of
monetary stimulus in helping the economy but never consider
that, at near-zero interest rates, the question is not one of
degree but rather of direction. Politicians either assail the Fed
for too much stimulus or too little, but never contemplate
whether the supposed stimulant is actually a sedative.
Academic economists largely avoid the messy arithmetic of
positives and negatives on this crucial issue in favor of more
mathematically challenging inquiries into more obscure topics.
Meanwhile, most media coverage, often aimed at the lowest
common denominator of financial understanding, feels little
compulsion to advance beyond the assumptions of Econ 101.
But the dismal recent history of monetary stimulus demands a
more thoughtful analysis. Japan has wallowed for 20 years with
zero interest rates without showing the slightest evidence of
stimulated demand. The mild U.S. recessions of 1991 and
2000 were followed by anemic economic recoveries, even
though the Federal Reserve in both cases lowered rather than
raised interest rates even as the economy was healing. Perhaps
most damning of all has been this miserably slow expansion
the slowest of all the economic recoveries since World War II.
While some will argue that this is due to extensive damage to
the financial system, it isnt. American financial institutions
have been very well capitalized for years. Rather, Americas

J.P. MORGAN ASSE T MA N A G E ME N T

AVOIDING THE STAGNATION EQUILIBRIUM

recovery may well have been hobbled by repeated bouts of

monetary stimulus that have starved households of interest
income, undermined confidence and undercut any incentive to
borrow ahead of higher rates.
We do not propose a complete rejection of traditional
economic assumptions. Steadily, if the Federal Reserve raised
rates to normal levels and beyond, the effects of rate hikes on
wealth, confidence and expectations would turn from tailwinds
to headwinds and the price effects of higher rates would
become more biting. Beyond a certain level, rising rates would
slow demand and the economy could, with some luck, achieve
a growth equilibrium, where the economy grows at its
potential pace, facilitated by a normal level of interest rates.
However, today after almost seven full years of a zero interest
rate policy, this seems like wishful thinking. Sadly, it is probably
more likely that we get stuck in a stagnation equilibrium
where a zero interest rate policy actually reduces demand in
the economy, prompting the Federal Reserve to prescribe even
further doses of a medicine that, for a long time, has been
impeding rather than promoting economic recovery.

10

AV O ID IN G T H E S T A GNATIO N EQ UIL IB RIUM

It is unlikely that policy-makers will recognize this but it still

doesnt mean that the situation is hopeless. In the fall of 2015,
while demand is still only growing slowly in the U.S. economy,
very low labor force and productivity growth are producing
both further labor market tightening and some mild upward
pressure on core inflation. If this continues, the Fed may feel
an obligation to follow its latest guidance to raise interest rates
to slow the economy. We dont believe this would actually slow
the economy, but in order for interest rates to regain their
normal role as an efficient allocator of capital and a governor
of aggregate demand, interest rates will have to rise through a
region where they could actually help the economy grow faster.
Besides, as the economy weathers the impact of slow global
growth, a high dollar and an inventory cycle, it will likely grow
a little more slowly over the next few quarters anyway.
If the Federal Reserve does finally tighten this year, Chair
Yellen will likely argue that the economy is strong enough to
handle it. In short, we believe the Fed should hike rates not
because the economy is strong enough to handle it but
because it is still weak enough to need the help that the first
few rate hikes would provide.

AVOIDING THE STAGNATION EQUILIBRIUM

GLOBAL MARKET INSIGHTS STRATEGY TEAM

Americas

Europe

Asia

Dr. David P. Kelly, CFA

Stephanie Flanders

Tai Hui

Andrew D. Goldberg

Manuel Arroyo Ozores, CFA

Yoshinori Shigemi

Anastasia V. Amoroso, CFA

Tilmann Galler, CFA

Kerry Craig, CFA

Julio C. Callegari

Lucia Gutierrez-Mellado

Dr. Jasslyn Yeo, CFA

Executive Director
Global Market Strategist
Madrid

Vice President
Global Market Strategist
Singapore

Vincent Juvyns

Ian Hui

Executive Director
Global Market Strategist
Luxembourg

Associate
Global Market Strategist
Hong Kong

Dr. David Stubbs

Akira Kunikyo

Executive Director
Global Market Strategist
London

Associate
Global Market Strategist
Tokyo

Maria Paola Toschi

Ben Luk

Executive Director
Global Market Strategist
Milan

Associate
Global Market Strategist
Hong Kong

Michael Bell, CFA

Anthony Tsoi, CFA

Managing Director
Chief Global Strategist
New York

Managing Director
Global Market Strategist
New York
Executive Director
Global Market Strategist
Houston
Executive Director
Global Market Strategist
Sao Paulo

James C. Liu, CFA

Executive Director
Global Market Strategist
Chicago

Samantha Azzarello

Vice President
Global Market Strategist
New York

David Lebovitz

Vice President
Global Market Strategist
New York

Gabriela D. Santos

Vice President
Global Market Strategist
New York

Hannah J. Anderson
Market Analyst
New York

Abigail B. Dwyer, CFA

Market Analyst
New York

Managing Director
Chief Market Strategist, UK & Europe
London
Executive Director
Global Market Strategist
Madrid
Executive Director
Global Market Strategist
Frankfurt

Vice President
Global Market Strategist
London

Managing Director
Chief Market Strategist, Asia
Hong Kong
Executive Director
Global Market Strategist
Tokyo
Vice President
Global Market Strategist
Melbourne

Market Analyst
Hong Kong

Alexander W. Dryden
Market Analyst
London

Nandini L. Ramakrishnan
Market Analyst
London

Ainsley E. Woolridge
Market Analyst
New York

J.P. MORGAN ASSE T MAN A G E ME N T

11

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