One of Alfred Hitchcock’s most memorable special effects, notably seen in the movie Spellbound, and copied by many other directors, is of a corridor receding in front of a protagonist. No matter how fast he moves, the destination gets further away, leaving the viewer with the conviction that he will never reach the end of the corridor. 
A similar perception may be building in the minds of investors waiting for the Federal Reserve to move to a normal level of short-term interest rates. This idea was further bolstered by Fed chair Janet Yellen at her press conference last Wednesday when she again emphasised that when the Fed begins to normalise rates they intend to do it very slowly.
To put some numbers on this, currently, the federal funds rate is in a range of 0-0.25 per cent. According to the median forecasts of the members of the FOMC, it is expected to rise to 0.50-0.75 per cent by the end of this year, 1.50-1.75 per cent by the end of next year, and 2.75-3.00 per cent by the end of 2017, still shy of the Fed’s estimate of 3.75 per cent for the federal funds rate in the long run.
The Fed has four meetings left this year, and eight in both 2016 and 2017. Assuming they only raise rates in quarter point increments and only at regularly scheduled meetings, they will raise rates in two out of four meetings this year, four out of eight next year and five out of eight in 2017.
The messaging was likely designed to reduce the risk of a violent market reaction to a first rate hike. However, an extremely slow lift-off in rates raises the possibility that the expansion ends before the Fed ever gets back to what it regards as a normal fed funds rate.
If this is the case, and a new recession brings with it a further flurry of rate cuts, the U.S. may face very low interest rates for many years to come, a prospect that has significant implications for the value of all financial assets.
Having said this, this remains a possibility rather than a probability. This is because the odds still favour demand growth outpacing supply growth in the US economy, even as interest rates rise. If this transpires, then not only will the Fed have to accelerate their tightening but both short-term and long-term interest rates could well end up above their long-term ‘normal’ levels, at least for a time.
On the demand side, the potential for a slowdown induced by rising rates is low for a number of reasons.
First, consumers have far more interest-bearing assets than interest bearing liabilities and most of their liabilities, (i.e. mortgages), are fixed rate. Therefore, higher interest rates will likely actually boost discretionary consumer income.
Second, rising interest rates may encourage stronger borrowing as consumers wish to get ahead of future rate increases and see higher rates as confirmation of a healthy economy. They may also encourage banks to lend if rising long-term interest rates improve net interest margins.
Third, rising interest rates could cause consumers and investors to try to divest themselves of bloated cash balances, boosting the demand for both goods and assets.
Fourth, higher interest rates could allow richer Americans to increase their estimates of the income that can be produced with a given amount of accumulated financial assets, encouraging them to spend.
Finally, higher long-term interest rates, by reducing measured long-term pension fund liabilities, could allow both corporations and state and local governments to increase current spending.
While higher interest rates would make it more expensive for businesses and consumers to borrow, on net, it is hard to see much drag from interest rates rising from current low levels. Indeed, it may well be that demand heats up rather than cools down when the Fed finally begins to tighten.
Meanwhile, the economy continues to exhibit very serious long-term supply constraints. In the decade that ended in the first quarter of 2015, real GDP growth averaged just 1.4 per cent, less than half the pace of the prior 50 years.
This slowdown is due in part to weaker productivity growth but even more because the retirement of the baby boom is throttling labour supply. Neither of these trends is likely to reverse, leaving the US economy with long-term potential growth rate of roughly 1.5 per cent.
If this is the case, then the most likely scenario is that the economy continues on a path of moderate demand growth, anaemic supply growth, falling unemployment and rising wage pressures. If all of this transpires, even this very dovish Fed may decide to raise short-term interest rates more aggressively leading, eventually, to somewhat higher long-term interest rates than most may anticipate.
There are a number of wild cards that could change this.
An even higher dollar could certainly slow demand more while the economy always remains vulnerable to an external geopolitical shock. Or it could be that the economy takes a temporary dip causing the Fed to overreact and, by heightening uncertainty, actually cause a more severe slowdown.
However, while investors should guard against the possibility that short-term rates never reach a level of 3 per cent or 4 per cent, the odds still seem stacked in favour of an economy over-heating rather than over-cooling.
David Kelly is global chief market strategist at JP Morgan Asset Management. The views expressed above are his own and should not be taken as investment advice.
