What if Fed rate hikes actually cause US economic growth?

(Bloomberg) — As the U.S. economy gained momentum month over month, adding hundreds of thousands of new jobs and confounding experts who warned of an imminent recession, some on Wall Street are beginning to entertain a fringe economic theory.

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What if the interest rate hikes of the past two years have boosted the economy? In other words, the economy may not grow despite high rates, but because of them.

In mainstream academic and financial circles, it’s an idea so radical it borders on heresy — something only Turkey’s former populist president, Recep Tayyip Erdogan, or the most ardent disciples of modern monetary theory would dare say publicly.

But new converts — along with a few who admit to being at least curious about the idea — say the economic evidence is impossible to ignore. By some key gauges — GDP, unemployment, corporate profits — the expansion is as strong or stronger now than when the Federal Reserve first started lifting rates.

This, opponents argue, is because the rise in benchmark rates from 0% to 5% will provide Americans with substantial income from their bond investments and savings accounts for the first time in two decades. “The reality is, people have more money,” says Kevin Muir, a former derivatives trader at RBC Capital Markets who now writes the investment newsletter The MacroTourist.

These people – and companies – are spending a large enough chunk of the newfound cash to boost demand and goose growth.

In a normal rate-hiking cycle, the additional spending from this group is not nearly enough to match the drop in demand from those who stop borrowing money. This would cause a classic Fed-induced recession (and a drop in inflation). Muir said the economy follows that pattern and “slowly.” “I think not, it’s probably more balanced and maybe even a little bit stimulating.”

Muir and other contrarians — Greenlight Capital’s David Einhorn being the most prominent among them — say this time is different for a few reasons. Chief among them is the impact of exploding US budget deficits. Government debt has risen to $35 trillion, double what it was a decade ago. That means the higher interest rates it is now paying on debt will flow an additional $50 billion or so into the pockets of American (and foreign) bond investors each month.

This phenomenon has fueled rising rates, not constrains, as economist Warren Mosler made clear several years ago. But as one of the most vocal proponents of Modern Monetary Theory, or MMT, his interpretation has long been dismissed as the teachings of an eccentric crusader. So there’s some vindication for Mosler now that he’s getting some mainstream audiences. “I’ve definitely been talking about this for a long time,” he says.

Muir readily admits that he was one of those who laughed at Mosler years ago. “You are crazy. It doesn’t make sense.” But when the economy took off after the pandemic, he decided to take a closer look at the numbers and, to his surprise, determined that Mosler was right.

‘really weird’

Einhorn, one of Wall Street’s best-known value investors, came to the theory earlier than Muir when he observed how slowly the economy was expanding despite the Fed pinning rates at 0% after the global financial crisis. Raising rates wildly clearly wouldn’t help the economy — a blow to borrowers, the benchmark rate of 8% is too powerful — to raise them to a more moderate level, he found.

Einhorn notes that US households hold more than $13 trillion in short-term interest-bearing assets, excluding mortgages, nearly tripling the $5 trillion in consumer debt. At today’s prices, that translates into a net gain for households of about $400 billion a year, he estimates.

“When rates go below a certain amount, they actually slow the economy,” Einhorn said on the Bloomberg Masters in Business podcast in February. He called chatter that the Fed would need to start cutting rates to avoid a slowdown “really weird.”

“Things are very good,” he said. I don’t think they are really helping anyone by lowering rates.

(Rate cuts are prominent as a consequence of the rate-hike-lift-growth theory supported by another camp on Wall Street. It claims that rate cuts push inflation down, not up.)

Frankly, the age-old maxim that high rates stifle growth is still firmly believed by the vast majority of economists and investors. As evidence of this, they point to rising delinquencies on credit cards and auto loans, and slowing, though still strong, job growth.

Mark Jandy, chief economist at Moody’s Analytics, spoke for conservatives when he called the new theory “off base.” But Jandy also concedes that “higher rates are causing less economic damage than in past periods.”

Like the converts, he cites another key factor for this resilience: During the pandemic many Americans were able to lock in uber-low rates on their mortgages for 30 years, shielding them from the pain of rising rates. (This is a key difference with the rest of the world; in many developed countries mortgage rates adjust rapidly as benchmark rates rise.)

Bill Eigen laughs when he recalls how many on Wall Street were predicting disaster as the Fed began raising rates. “They’ll never get past 1.5% or 2%,” he quipped, “because that would collapse the economy.”

Eigen, a bond fund manager at JPMorgan Chase, isn’t a full proponent of the new theory. He is more in the camp of those who sympathize with broad contours of thought. That attitude has helped him recognize the need to refashion his portfolio, loading it with cash — putting him in the top 10% of active bond fund managers over the past three years.

Eigen has two side hustles outside of JPMorgan. He runs a fitness center and a car repair shop. In both places, people continue to spend more money, he said. Especially retirees. They, he notes, are probably the biggest beneficiaries of higher rates.

“Suddenly, all this disposable income goes to these people,” he says. “And they’re spending it.”

–With assistance from Matthew Bosler.