FED RAISES RATES: WE'RE IN FOR A BUMPY RIDE

The Fed raised it's benchmark interest rate by a quarter of a percent last Wednesday to a range between 0.25%-0.5%. The increase itself was trivial; however, as a signal of the Fed's intentions, the event is laden with portents. The Federal Open Market Committee (FOMC) statement for December 16, 2015 stated: 

The Committee expects that economic conditions will evolve in a manner that will warrant only gradual increases in the federal funds rate; the federal funds rate is likely to remain, for some time, below levels that are expected to prevail in the longer run. However, the actual path of the federal funds rate will depend on the economic outlook as informed by incoming data.

Implicit in the Fed's statement: a) The economic recovery is real but fragile, and therefore, the Fed should not risk undermining the economy with rapid interest rate increases that could discourage consumer spending and business investment and b) Inflation is unlikely to rekindle any time soon, and therefore the Fed can maintain its accommodative policy "for some time." (A rekindling of inflation would require the Fed to raise interest rates aggressively to dampen economic activity as a means of maintaining price stability.) My analysis suggests a different scenario, in which inflation accelerates faster than the Fed, and Wall Street generally, expect, prompting faster interest rate increases than the leisurely pace envisioned by the Fed. Here's why: 

To create the the zero-interest-rate environment fostered by the Fed over the past 7 years, the central bank has pumped unprecedented amounts of new money into the banking system without rekindling inflation. The reason for this apparent anomaly is that the velocity of money (the frequency with which money is spent) has plunged, avoiding the inflationary paradigm of "too much money chasing too few goods." Banks have been content to passively allow much of their vast accumulations of surplus reserves, costing them nothing, to languish in low-paying Treasurys, rather than aggressively lending them to consumers and businesses to stimulate economic activity. Hence the sluggish GDP growth in recent years.

However, as the Fed now begins to raise rates, banks, faced with the prospect of paying depositors for the use of their money, will be forced to lend more aggressively to show a profit on previously idle, cost-free reserves. GDP growth will pick up and THE VELOCITY OF MONEY WILL INCREASE, FUELING INFLATION, eventually forcing the Fed to raise rates more aggressively than previously anticipated. 

It won't happen right away, because starting from a zero-interest-rate base, it will take a while for interest rates to rise to the point where payments to depositors prod the banks into a more aggressive lending stance. However, once these payments  become significant -- perhaps around 2% for the Fed funds rate -- I expect an extended vicious cycle between rapidly rising interest rates and accelerating inflation. The Fed will chase its tail until such time as high interest rates eventually discourage private borrowing, curbing economic growth and inflation. In the process, bonds will tumble as interest rates rise, eventually prompting stocks to crash as the economy falters. There is no free lunch. The money the Fed pumped into credit markets to rescue the economy will come back to bite us.  

"Fasten your seat belts, folks. We're in for a bumpy ride.”