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Will 2014 Mean the End of ‘Cheap Money?’

By Kurt Avard - Mar 25, 2014 at 1:30PM

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Despite strong trending, the economy may not be able to sustain itself just yet

Janet Yellen may be a departure from recent Federal Reserve chairpersons, but she recently showed her relative inexperience as she stumbled through her first press conference. Failing to clarify previously made comments on the health of the U.S. market, bond markets fell as the new chairwoman's offhand remarks helped drive the Dow Jones Industrial Average down nearly 150 points.

Make no mistake, Yellen is an excellent economist, but the garbled message she delivered to the public begs the question: will 2014 be the year when the U.S. cuts its supply of cheap money? 

What's cheap money?
Cheap money refers to a market condition in which a given economy seeks to stimulate growth by creating employment opportunities. This is accomplished by lowering reserve requirements for banks (that is, the amount of money banks need to have on hand to cover day-to-day transactions), which in turn allows banks to give out more credit in the form of loans. Aided by lower interest rates, cheap money is great for a struggling economy, but less helpful for naturally growing economies (as it can potentially lead to economic bubbles). 

The economy has been rebounding since the beginning of 2014. With wages up and 175,000 new jobs created in February, American markets seem to be warming themselves up nicely in the wake of deep snow and miserable weather. With the ongoing taper potentially ending late this year, one could argue that interest rates need to rise to give the economy room to expand, without an artificial boost from monetary policy.

Given that the 175,000 jobs created last month represents a three-month low (and this workforce expansion came in the face of the weather), the economy is definitely on a good path. With unemployment falling below Yellen's benchmark of 6.5% (although this has recently been abandoned in favor of a currently unknown figure), the economy is recovering, but it may not be time to consider raising rates.

Is that such a bad thing?
That being said, Federal Reserve recent reports indicate that it will raise rates by at least 1% by the end of 2015 and to 2.25% by the end of 2016. While this does not seem like a marked increase, this would make U.S. bonds more attractive, at least in the short term. Short-term yields are already up to a 6-month high of .448%, but with longer-term bonds more minimal in their growth, investors are worried that a rise in interest rates will slow inflation in the long term.

While low inflation is good, having inflation too low will stagnate the economy and remove the forward progress the Fed's moves have made in recent months. With U.S. inflation at just over 1% in February, the recent surge in the economy may not yet be enough to create a self-sustaining cycle. That is, government intervention (in the form of low rates) may show the economy to be less strong than it seems, and allow for another slowdown. 

Is 2014 the end of cheap money?
In my opinion -- no. The U.S., though continuing to recover, is not yet ready for raised interest rates. This is not the fault of Yellen's comments, although her remarks did expose the tenuousness of the economy. Rather, this is due to unmanageable factors such as the weather (still affecting areas of the country with freak snowstorms and adverse conditions). 

What 2014 may be is a barometer for measuring the potential for future interest rates. 2015 may be the year to tighten the money supply, but higher Federal rates now may not be the best medicine for our economy.

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