Great news: the Fed is likely to raise rates sooner rather than later

Since all the evidence to date suggests that the economy continues to improve on the margin, the FOMC (in their statement released today) is right to think that they may have to raise short-term interest rates sooner than expected. The market agrees, and that makes higher-interest-rates-sooner-than-expected virtually certain. At this point, I'm guessing that the FOMC will begin to raise rates no later than March of next year. However, at the rate things are improving, there is no reason they couldn't begin to "lift off" sooner than the end of this year.

This amounts to a triple dose of good news for investors: 1) the economy is definitely improving, 2) short-term interest rates are going to rise to more attractive and reasonable levels within the foreseeable future, and 3) all of this should serve to boost optimism and reduce uncertainty about the economy's prospects.

Here are some charts updated for recent announcements that are also germane to investors' decisions going forward.

The outlook for commercial real estate looks solid, as I noted earlier this week, and the July housing starts and recent survey of builder sentiment (see graph above) released today point to continued improvement—albeit relatively modest—in the residential market.

Architectural billings in July suggest that the outlook for commercial construction activity is positive and improving.

Nominal GDP has been growing at about a 4% pace for most of the past four years, yet the Fed has kept short-term rates extremely low. This is unsustainable. The sooner the Fed gets short-term rates back to levels consistent with 4% nominal GDP growth, the better. As the chart demonstrates, there is no reason to think that higher interest rates are detrimental to growth. Higher interest rates are instead a logical consequence of growth.

The CPI has increased at about a 2.3% annualized pace for more than 10 years. At this rate, prices increase by over 25% every decade. That's not insignificant, and it's not even close to deflation. It's not healthy either. In fact, it transfers hundreds of billions of dollars from the private sector to the federal government every year. How? The interest rate on cash, savings deposits, T-bills, bank reserves, and other short-term instruments is about 2% lower than the inflation rate. That means that holders of cash and short-term securities are losing 2% of their purchasing power every year, and the federal government and the Fed (which transfers any and all profits on its balance sheet holdings to the Treasury) are the direct beneficiaries.

It makes little or no sense for the Fed to continue to keep real short-term interest rates in deeply negative territory. It's potentially quite destabilizing, since it encourages excessive borrowing and leveraging and speculative activity. Eventually it could become a potent source of higher inflation, since negative real interest rates undermine the demand for money at a time when the Fed is still eager to supply it, and that is the classic prescription for an inflationary environment.

Over the past six months, both the total and the core version of the CPI have accelerated: consumer price inflation now is running somewhere between 2 and 2.5%. With short-term interest rates pegged at 0.25% or lower, real short-term interest rates are about -2% or worse. There are at least $10 trillion of short-term deposits and securities paying negative real interest rates, which amounts to a wealth transfer of $200 billion or more from the private to the public sector. This weakens the private sector—the source of most of the economy's strength—and strengthens the public sector, which is the sector with the highest propensity to squander scarce resources. It's a prescription for chronic economic weakness. It once made sense given the public's tremendous risk-averseness and the world's huge appetite for money, but with every day that brings news of an improving economy, it makes less and less sense.

Short-term interest rates are still quite low relative to current inflation trends. Holders of 5-yr Treasuries are losing purchasing power at the rate of about 0.5% per year. With inflation at 2%, 5-yr Treasury yields should be closer to 3%, or about double their current level.

Fortunately, it doesn't look like risk markets have become overvalued—yet. But the Fed could well find itself with this problem before too long. For now, credit spreads (see graph above) are not abnormally low, and PE ratios are only modestly above average (see graphs below). But if borrowing costs remain in negative territory—thus encouraging borrowing and leverage—the prices of risk assets could experience significant upside potential that at some point could become vulnerable to a crash. We're not there yet by any stretch, but that is what we need to watch out for.

The first of the above two graphs shows the conventional measure of PE ratios: equity prices divided by 12-mo. trailing earnings. The second uses the Shiller CAPE method: equity prices divided by a 10-yr moving average of earnings. (For a more detailed discussion of equity valuations, see this post from one year ago. Equities are less attractive today than they were then, but valuations do not appear to be stretched or unreasonable, given the exceptionally strong performance of corporate profits since 2009.) PE ratios by both measures are only modestly above their long-term averages.