Avoiding the stagnation equilibrium - Amazon S3 · Avoiding the stagnation equilibrium IN BRIEF ... served as a senior strategist/economist at SPP Investment Management, Primark Decision

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How raising rates from a low level can boost economic growth

Avoiding the stagnation equilibrium

IN BRIEF

• 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.

2 AVOIDING THE STAGNATION EQUILIBRIUM

AVOIDING THE STAGNATION EQUILIBRIUM

Dr. David P. Kelly, CFAManaging Director Chief Global Strategist

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.

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.

AUTHORS

Ainsley E. WoolridgeMarket AnalystNew York

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 Bachelor’s degree in finance, a concentration in accounting and a minor in international business.

J .P. MORGAN ASSET MANAGEMENT 3


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 Fed’s 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.

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 didn’t 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 isn’t that the economy can handle the pain but rather that it could do with the help.

LOOKING AT TRANSMISSION MECHANISMS

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

Raising short-term rates from near zero should boost economic demand, although raising rates from higher levels could reduce itEXHIBIT 1: NON-LINEAR RELATIONSHIP BETWEEN SHORT-TERM INTEREST RATES AND OUTPUT

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.



Raising interest rates should be a big net positive for household incomeEXHIBIT 2: INTEREST-BEARING ASSETS AND INTEREST-BEARING LIABILITIES AS A PERCENT OF GDP

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

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:

• The 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.

• The 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.

• The 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.

100%

90%

80%

70%

60%

50%

40%

30%

20%

10%

0%

Interest bearing assets

Liabilities

Liabilities ex. home mortgages

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



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 short-term interest rates will sink the housing market. This might be true at much higher rates but not at today’s super–low rates. The key to seeing this is to recognize that potential home-buyers 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.

1Assets 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. 2This 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 Reserve’s 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.3Apart from regulatory concerns, the Federal Reserve’s huge purchases of mortgage securities may be impeding mortgage supply by holding mortgage rates at artificially low levels. If banks believe the Fed’s 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%.

Rising rates haven’t boosted the savings rate in the pastEXHIBIT 3: FEDERAL FUNDS RATE AND 6-MONTH MOVING AVERAGE PERSONAL SAVINGS RATE

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.

12%

10%

8%

6%

4%

2%

0%

Federal funds rate

Personal savings rate

Correlation: -0.01

’91 ’94 ’97 ’00 ’03 ’06 ’09 ’12 ’15’88



Increasing rates from low levels is associated with rising stock pricesEXHIBIT 7: CORRELATIONS BETWEEN WEEKLY STOCK RETURNS AND INTEREST RATE MOVEMENTS

Source: FactSet, Standard & Poor’s, 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.

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

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.

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.

Monthly mortgage payments are well below average levelsEXHIBIT 4: AVERAGE MORTGAGE PAYMENT AS A % OF HOUSEHOLD INCOME

Down payments are well above average levelsEXHIBIT 5: DOWN PAYMENT AS A % OF HOUSEHOLD INCOME

Credit scores for approved mortgages remain extremely highEXHIBIT 6: AVERAGE FICO SCORE BASED ON ORIGINATION DATE

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-0.2

-0.3

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3-MONTH TREASURY YIELD0% 2% 4% 6% 8% 10% 12% 14% 16%

40%

35%

30%

25%

20%

15%

10%

Average: 19.6% Aug. 2015:12.4%

’75 ’78 ’81 ’84 ’87 ’90 ’93 ’96 ’99 ’02 ’05 ’08 ’11 ’14

65%

60%

55%

50%

45%

40%

Average: 53.0%

’78 ’81 ’84 ’87 ’90 ’93 ’96 ’99 ’02 ’05 ’08 ’11 ’14’75

Aug. 2015:54.4%

760

740

720

700

680’05 ’06 ’07 ’08 ’09 ’10 ’11 ’12 ’13 ’14 ’15’04

July 2015:745



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 Fed’s 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 country’s 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.

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 wasn’t 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.

The U.S. dollar has not increased in reaction to the start of that last three rate hiking cyclesEXHIBIT 8: VALUE OF THE U.S. DOLLAR: INDEXED TO 100 IN THE MONTH OF FIRST RATE HIKE

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.

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93-6 -5 -4 -3 -2 -1 0 1 2 3 4 5 6

MONTH

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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 home-sellers 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 cycleEXHIBIT 9: 3-MONTH T-BILL TO 10-YEAR TREASURY BOND ON THE DAYS OF THE FIRST AND LAST RATE INCREASES OF A HIKING CYCLE

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

5While this is easiest to see in the case of home buyers, exactly the same effects should occur in the business sector.

June 2004 – July 20066.0%

4.0%

2.0%

0.0%

3m 1y 2y 3y 5y 7y 10y

Jun. 30, 2006

Jun. 30, 2004

10-year – 3-month

Jun. 30, 2004: 3.29%Jun. 30, 2006: 0.14%

June 1999 – June 20008.0%

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3m 1y 2y 3y 5y 7y 10y

May 16, 2000

Jun. 30, 1999

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Jun. 30, 1999: 1.03%May 16, 2000: 0.23%

March 1988 – February 198910.0%

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3m 1y 2y 3y 5y 7y 10y

Feb. 24, 1989

Mar. 24, 1988

10-year – 3-month

Mar. 24, 1988: 2.55%Feb. 24, 1989: 0.42%

February 1994 – March 19958.0%

6.0%

4.0%

2.0%

3m 1y 2y 3y 5y 7y 10y

Feb. 1, 1995

Feb. 4, 1994

10-year – 3-month

Feb. 4, 1994: 2.64%Feb. 1, 1995: 1.59%

May 1983 – August 198414.0%

12.0%

10.0%

8.0%

3m 1y 2y 3y 5y 7y 10y

Aug. 31, 1984

May 24, 1983

10-year – 3-month

May 24, 1983: 1.76%Aug. 31, 1984 1.73%




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 isn’t. American financial institutions have been very well capitalized for years. Rather, America’s

The confidence effect: What does the Fed know that we don’t?

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 Fed’s 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 don’t?

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 Fed’s tightening.

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.

Rate increasing cycle First

increaseLast

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.

12-month change following:

Rate increases from very low levels generally acts to boost confidenceEXHIBIT 10 : CHANGE IN CONSUMER CONFIDENCE INDEX 12 MONTHS AFTER THE FIRST AND LAST RATE INCREASES OF A CYCLE



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.

It is unlikely that policy-makers will recognize this but it still doesn’t 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 don’t 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.



Americas

Dr. David P. Kelly, CFAManaging DirectorChief Global StrategistNew York

Andrew D. GoldbergManaging DirectorGlobal Market StrategistNew York

Anastasia V. Amoroso, CFAExecutive DirectorGlobal Market StrategistHouston

Julio C. CallegariExecutive DirectorGlobal Market StrategistSao Paulo

James C. Liu, CFAExecutive DirectorGlobal Market StrategistChicago

Samantha AzzarelloVice PresidentGlobal Market StrategistNew York

David LebovitzVice PresidentGlobal Market StrategistNew York

Gabriela D. SantosVice PresidentGlobal Market StrategistNew York

Hannah J. AndersonMarket AnalystNew York

Abigail B. Dwyer, CFAMarket AnalystNew York

Ainsley E. WoolridgeMarket AnalystNew York

Europe

Stephanie Flanders Managing DirectorChief Market Strategist, UK & EuropeLondon

Manuel Arroyo Ozores, CFA Executive DirectorGlobal Market StrategistMadrid

Tilmann Galler, CFA Executive Director Global Market Strategist Frankfurt

Lucia Gutierrez-Mellado Executive Director Global Market Strategist Madrid

Vincent JuvynsExecutive DirectorGlobal Market Strategist Luxembourg

Dr. David Stubbs Executive Director Global Market StrategistLondon

Maria Paola Toschi Executive Director Global Market Strategist Milan

Michael Bell, CFA Vice PresidentGlobal Market Strategist London

Alexander W. Dryden Market Analyst London

Nandini L. Ramakrishnan Market Analyst London

Asia

Tai HuiManaging DirectorChief Market Strategist, AsiaHong Kong

Yoshinori ShigemiExecutive DirectorGlobal Market StrategistTokyo

Kerry Craig, CFAVice PresidentGlobal Market StrategistMelbourne

Dr. Jasslyn Yeo, CFAVice PresidentGlobal Market StrategistSingapore

Ian HuiAssociateGlobal Market StrategistHong Kong

Akira KunikyoAssociateGlobal Market StrategistTokyo

Ben LukAssociateGlobal Market StrategistHong Kong

Anthony Tsoi, CFAMarket AnalystHong Kong

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