More than six and a half years ago, the Federal Reserve cuts interest rates to near zero to combat economic recession. It promised to maintain its exceptionally low rates just to aid the economy and to provide a form of assurance to investors.
Fast forward to seven years later, the Fed has announced last month that interest rates would be put on hold, again. In case you are unclear of how things are going to unfold, let’s take a look at how low interest rates affect the entire economy system.
Y = C + I + G + (X-M)
Where Y = Gross Domestic Product (GDP)
C = Consumption
I = Investment
G = Government Spending
X = Exports
M = Imports
The size of a nation’s economy is the total value of the spending on goods and services in the economy in a year. Consumption by consumers, investments, government spending and net exports form four important parts of any economy. When interest rates are low,
- Consumers have little to no incentive to save, and it induces them to borrow to spend. This may not necessarily refer to pure household spending, as consumers would definitely want to make their money grow for them by investing in real estates and properties.
- It spurs investment because businesses invest in productive equipment which creates employment and therefore more goods and services.
During times of a recession, inflation is likely to fall in order to help the country to become more competitive. With increased government spending and net exports in addition to increased consumption by individuals and businesses to spur the economy, a nation would soon be experiencing economic growth.
↑Y = ↑C + ↑I + ↑G + ↑ (X-M)
As growth happens, unemployment falls as more people are employed to provide goods and services. However, with an increase in aggregate demand, inflation looms as a risk because prices should naturally begin to rise. When prices rise undesirably fast, not only would inflation set in, it also creates the scene for a financial bubble to grow. Interest rates and/or exchange rates should then rise (may not be concurrent) to combat inflation and prevent the economy from overheating.
With exceptionally high inflation and interest rates, consumers and businesses become more unwilling to spend as it increases their costs of borrowing. In the longer term, the economy would eventually contract which is all part and parcel of a healthy economic cycle. We need to also note that low inflation is necessary to keep an economy healthy as well.
Economic scar from 2008 still lingers
Seven years ago, the global financial crisis left an economic scar so deep that the Federal Reserve took extraordinary actions in response to the financial crisis to keep interest rates and exchange rates at a low level to serve only one objective: To combat recession and to help stabilize the economy and financial system.
- In 2012, The Fed announced that it would keep rates near zero at least until the unemployment rate fell below 6.5 percent. That threshold has already been crossed in April 2014.
- In Sept 2015, it was announced that the US unemployment rate has fell to a seven-year low of 5.1 percent. Information have already been received that economic growth in US grew by an annualized rate of 3.7%, up from an estimated 2.3% where this growth was contributed by strong consumer and government spending, and higher exports. Even Janet L. Yellen, the Fed’s chairwoman has equally agreed that the recovery from the Great Recession has progressed sufficiently far and domestic spending has been satisfactorily robust that an argument can be made for a rise in interest rates.
Months and months of discussion to raise rates, the Fed decided to leave rates unchanged, again. Their reasons were due to requiring more time to evaluate the impacts it can have on the US. No doubt, a Fed hike would definitely affect mortgage rates, property prices, costs of borrowing and savings (Read: Are You Ready For An Interest Rate Hike?), and on a bigger scale, multinationals with a lot of debt would far worse as a rising dollar makes their goods and services more expensive and this makes it even harder to finance their debts. It could also prompt investors to pull money out of emerging economies and reduce demand for imports from Europe and other developed countries.
But if the US economy have already proved to be resilient in recent economic data, not raising the interest rates seem to have detrimental effects as well. Sukhdave Singh, Deputy Governmor of Bank Negara Malaysia has said that, “delaying the increase would not solve the situation, if it is a case that the emerging markets have taken on too much debt, then there will be a day of reckoning.”
“Too much debt, too little growth”
The International Monetary Fund (IMF) concluded its annual meeting with a warning to central banks that if they do not continue to support growth with low interest rates, then the global economy risks another crash. However, in a study launched in Lima to coincide with the IMF’s annual meeting, the G30 group of experts have mentioned that keeping the cost of borrowing too low for too long was leading to a dangerous accumulation in debt. Indeed, interest rates have been too low for an exceptionally long time, causing debt burdens to be at an all-time high. Despite so, growth rate has not been proportionate and appears to be so diminutive that what may seem only right to increase interest rates, is now deemed as what would shake and throw the economy off balance again.
Even though inflation may be low and stable, Jean-Claude Trichet, former president of the European Central Bank, have mentioned that dangerous credit-driven imbalances can also accumulate. This was already seen during China’s stock market crash in July where investors leveraged on borrowed money to purchase shares, causing share prices to hit an all-time high before crashing down. When that happens, the People’s Bank of China (PBoC) announced a cut in its reserve requirement ratio and interest rates again, hoping to stimulate further investments. But what is more contradictory is that China has already cut its rates five times since November, yet it is not seen to be giving the economy a substantial economic growth. Instead, it gave rise to a debt-fuelled global growth model which caused the crash to be inevitable. With interest rates at an all-time low, with commodities prices falling, investors are not likely to consider cash, bonds and even commodities as part of their portfolio as these investments may not generate adequate returns. This leaves equity markets more appealing for investors to increase their investments in, causing credit growth to build up again, and the cycle repeats. An equity market heavily dependent on borrowed money would only cause investors to nurse big losses that would take a long time to heal.
The Bank of International Settlement (BIS) said in its 85th annual report that, “Risk taking in financial markets have gone on for too long. And the illusion that markets will remain liquid under stress has been too unescapable.” Claudio Borio, head of the BIS’s Monetary and Economic Department, has also summed up the state of the global economic and financial system as one of “too much debt, too little growth and too low interest rates.”
Although the pursuit of “exceptionally low” interest rates was in response to the 2007-2008 global financial crisis and the deflation panic triggered by last year’s plummet in global oil prices, keeping rates at excessively low levels risks imposing “serious damage” on the financial system and may worsen market volatility. This is not to forget it limits policymakers’ response to the next recession when it comes. Ever since the financial crisis in 2008, more than a dozen central banks in Sweden, Israel, Canada, South Korea, Australia, Chile, and more have tried to raise interest rates only to cut them again. One example is the Bank of Israel, under Stanley Fischer, who is now Fed’s vice chairman, was among those who raised rates just as a global recovery took place, from 0.5% in September 2009 to 3.25% in May 2011. With Israel’s economy stricken by Europe’s slump and global inflation slowing, Mr. Fischer’s successor, Karnit Flug, has since pushed rates back down to 0.10%.
Federal Reserve Governor Lael Brainard has also warned against raising interest rates too soon as the US economy may not be resilient enough and to overcome deflationary risks imported from abroad. Investors are becoming restless waiting. There seems to be too much uncertainty lingering from not knowing when to step into the stock market, when the Fed would increase rates and how investors could make adjustments to their portfolio. Tharman Shanmugaratnam, Singapore’s Deputy Prime Minister and former head of the IMF’s governing committee has agreed that many emerging-market central governors and some others are keener to see the Fed get over and done with it, not because they truly want to see interest rates rise, but because they wanted to reduce uncertainty.
Of course, there are bound to be winners and losers should the Fed decide to increase rates, it just depends whose shoes we are in.
The Fed next meets on Oct 27-28.
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