The US Federal Reserve has learned the lessons of the past and interest rates are likely to rise gradually and peak at much lower levels than in the past, says Nick Samouilhan.
- If history is a guide, the hunt for income is likely to remain intense despite the recent rise in US interest rates
- It is certainly worth looking back to what happened to interest rates following the Great Depression
- The Federal Reserve has admitted it made mistakes back then and has vowed not to repeat them
- Today, global growth remains weak with the IMF warning it will disappoint in 2016
- In this environment, interest rates are likely to rise gradually in the UK and peak at much lower levels than investors were accustomed to prior to 2008
The value of history as a guide to the future divides opinion like few other subjects. Henry Ford famously regarded it as bunk, a view reputedly shared by Tony Blair. Winston Churchill took the opposite line, writing that “the farther back you can look, the farther forward you are likely to see”.
Investors have more reason than most to value the predictive role that the past can play. After all, the economic and investment cycle provides a constant reminder of how history replays. Unfortunately, the phrase “this time is different” sums up the equally consistent ability of many investors to forget the past.
On that basis it is worth putting the US Federal Reserve’s (Fed) recent decision to raise interest rates into historical context by looking back at what happened to monetary policy in the 1930s. This period is particularly relevant, given that the global financial crisis represented a shock on a similar scale to the Wall Street crash of 1929.
Superficially, there are striking similarities between then and now. The Fed’s December 2015 interest rate hike took place around seven years after the collapse of Lehman Brothers in October 2008. Similarly, in 1936, the Fed tightened monetary policy seven years after the Wall Street crash.
The Fed made many mistakes in the 1930s, but the 1936 decision was one of the worst. The central bank acted even though the recovery from the Great Depression was far from certain and at the same time as the government was cutting spending and raising taxes. The result was the third-worst recession in US history, with real GDP falling by 11 per cent and industrial production by nearly a third.
The recession of 1937-38 still has policy lessons for today, according to Professor Douglas Irwin of Dartmouth University in the US. He explains that “it suggests that, in a weak recovery, a pre-emptive monetary strike against inflation [which was very low at the time, as it is today] is capable of producing a devastating recession.”
The conclusions drawn by Irwin, who has worked at the Fed in a non rate-setting capacity, reflect those of other senior officials that have served the central bank in the post-crisis period. In 2002, future chairman Ben Bernanke, a student of the Great Depression, said that central bankers were responsible for much of the suffering in the 1930s. He added that “we won't do it again”. This perhaps explains why the Fed took so long to raise interest rates this time round.
Indeed, the fact that central banks and governments around the world have learned the lessons of the Great Depression is one of the profound differences between the 1930s and today. Following the financial crisis, the authorities instituted massive and coordinated reflationary policies. Moreover, while the US central bank finally raised interest rates at the end of 2015, monetary policy overall remains loose both in the US and globally.
Even so, while the world has not suffered a repeat of the Great Depression, global growth remains weak. At the end of 2015, Christine Lagarde, the head of the International Monetary Fund, warned that growth would disappoint in 2016 and that the outlook for the medium-term had deteriorated. She cited the prospect of rising interest rates in the US and slower growth in China. This background reinforces our view that the hunt for income will remain intense over the next few years. Interest rates in the UK are likely to rise gradually and peak at much lower levels than investors were accustomed to prior to 2008.