December 2015: the month the Federal Reserve raises interest
rates?
Many feel that the Federal Reserve will raise
rates this December, resulting in the first rise since 2006. Indeed, Federal
Reserve Chairwoman Janet Yellen stated that a rise in interest rates was a
“live possibility”.
On average, 250 000 jobs are being created in
the US economy each month and unemployment has halved from its peak level in
2009. In October, unemployment decreased by 271 000. Moreover, the US
unemployment rate is at 5.1pc, whilst the natural rate of unemployment is
between 4.9 and 5.2pc. Therefore this increase in employment is expected to fuel
inflation, as more people will have a larger income, and so would consume more.
This would create a multiplier effect, creating further jobs in the economy and
increasing inflation still further. Therefore, as it is the Fed’s role to
ensure that inflation meets its 2pc target, it should increase interest rates in
order to ensure the multiplier does not result in inflation exceeding this
target.
However, although more jobs were created in
October than the average, this by itself does not provide a strong case for the
Fed to raise rates. Firstly, we must remember the statistical idea of regression to the mean. Nevertheless,
if more than 271 000 jobs are created in November, then we may be justified in believing
that the US is on the road to recovery and so rates should increase.
However, although employment may increase,
inflation may not necessarily rise in line with employment. This is because the
most significant cause of the low rate of inflation in the US currently is the low price of commodities from China. It
seems highly unlikely that prices will increase, especially since China is
expected to shift from focusing on the manufacturing sector to specialising in
services and consumption. Thus, it is likely that global oil prices will remain
subdued, and thus the cost of manufactured goods will also. Therefore, it seems
that the Fed needs to balance the potential inflationary pressures which would
arise due to the multiplier effect, along with the potential deflationary
pressures from depressed global demand, in order to decide whether to increase
interest rates.
However, it should be noted that the reduced
price of imports may serve to increase
consumer spending in the domestic economy, because citizens’ real wages
would increase. This would accelerate the multiplier effect in the domestic
economy. Indeed, the rate of inflation in the US economy, excluding food and
oil, has increased by 0.2pc in October. Indeed, consumer spending grew by 3.2pc
in the third quarter. Therefore, it seems apparent that the Fed should increase
rates, as the US faces will face inflationary pressures both from increased
employment and from the effect of cheaper imports.
On the other hand, due to this wave of
deflation and reduced increase in inflation, rather than tightening monetary
policy, other central banks across the world have loosened their monetary
policies. For example, Mario Draghi has extended his Quantitative Easing
programme for the Eurozone. Moreover, it is likely that the Bank of Japan will
follow in order to increase inflation, as currently it is officially back in a
recession.
Moreover, since 2014 the dollar has been
appreciating, thus resulting in cheaper imports and more expensive exports for
the US. Therefore, it has been stated that the Federal Reserve does not need to
raise interest rates since the markets have tightened monetary policy. Further
tightening may result in a decrease in the rate of inflation, meaning that the
Federal Reserve would not meet its aim of reaching 2pc inflation. Although this
in itself does not provide a strong argument against inflation, it does
highlight that the Fed should not increase the interest rate too much. It
should perhaps only increase the rate by 0.25pc, before evaluating the effect
of the raise and then deciding what to do further in a couple of months’ time.
Currency wars
However, sceptics argue that should the Fed
raise interest rates, then this would result in the dollar appreciating, as
more investors choose to invest into the US. This would result in exports
becoming more expensive, reducing their demand and thus the total value of
exports. An appreciation would also lead to imports becoming relatively cheaper.
This could therefore increase the demand for imports, reducing demand for
domestically produced products and so potentially reducing the rate of increase
in inflation. Therefore, the total value of imports is likely to rise. The
combined effect would be for the current account to deteriorate. However, due
to the potential for decreased aggregate demand within the US economy, this
could lead to the rate of increase in inflation decreasing, thus pushing the US
economy back into a recession. However,
as mentioned above, this may not necessarily decrease aggregate demand, because
US citizens may spend more in the domestic economy, increasing the multiplier
in the economy, and thus supporting an increase in the rate.
Nevertheless, the appreciation of the dollar
is likely to accelerate capital outflow
from emerging markets and to the US, thus depreciating the currencies of
the developing world whilst appreciating the US dollar. This would have a negative effect on emerging
markets since their debt is heavily
dominated in US dollars and this would increase as the dollar appreciates. Indeed,
corporate debt in emerging markets already currently accounts for 75% of GDP, a
25% increase since 2008. This would not inevitably prove to have a negative
effect, but the fact that there has been a reduced global demand for exports
from these emerging nations means that GDP will decrease while the debt burden
increases due to both the strength of the dollar and the reduction in GDP. Moreover,
emerging markets who peg their currency against the dollar will see their currencies appreciate, and so their
exports will become less competitive and so their GDP is also likely to fall. Thus,
from the point of view of emerging markets, the Fed’s decision to interest rate
would not be in their best interests. Moreover, an increase in interest rates
could increase the rate of capital outflows from China, as assets dominated in
US-dollars become more attractive. However, this would be damaging for the US
economy in the long-run since China is a major buyer of US Treasury bonds.
Animal Spirits
On the other hand, a rise in interest rates may increase
investor confidence. After the publication of the Federal Reserve’s minutes,
the Dow Jones increased by 0.9%, whilst the Standard & Poor 500 increased
by 1%. A slight increase in interest rates may signal to the world economy that
the US has finally recovering from the Financial Crisis. Therefore, this could
also increase investment by businesses, thus leading to further employment
opportunities.
However, others would argue that an increase
in interest rates would cause ‘Zombie
companies’ to become bankrupt, as they would no longer benefit from extremely
low interest rates. They would not be able to borrow at high interest
rates as they would not be profitable enough. Therefore, sceptics would argue
that the Fed should not increase the interest rate, as unemployment would
increase following the closure of these ‘Zombie companies’. However, this can
not be seen as a strong case against an increase in the interest rate. Indeed,
should these ‘Zombie companies’ cease to exist, then their employees would be
released and can then be hired by more successful enterprises, thus ensuring
allocative efficiency.
Consumers
An increase in interest rates would ensure
that savers receive more for their deposits. However, an increase in interest
rates would also mean that credit card bills, car loans and mortgages would
become more expensive to finance. An increase in the interest rate for
mortgages and car loans would mean that consumers would have less disposable
income left to spend in the economy and increase aggregate demand. Moreover, an
increase in interest rates would also reduce demand slightly from potential new
homeowners and car owners as they would find these purchases more expensive and
so would postpone their purchase into the future. Therefore, although on a
microeconomic level most consumers may not wish to see an increase in interest
rates, it would help the Fed to ensure that they do not overshoot the 2%
inflation target.
To Hike or not to hike?
Following a moderate increase in both
inflation and employment, there is a relatively strong economic case which
favours the Fed increasing interest rates. Although oil prices are likely to
remain subdued, this should ensure that Americans will have more disposable
income to spend on domestic goods, thus stimulating further employment through
the multiplier effect. However, the rate increase should not be too high. Indeed,
Japan’s experience has highlighted that if monetary policy tightens too early
then severe economic costs could ensue, namely persistent deflation. This is
further supported by recent experiences in the Eurozone- the ECB increased
interest rates in 2011, but the result was a double-dip recession, forcing the
ECB to bring rates crashing back down. A small increase, say of 0.25pc, would
help to increase business confidence and would be small enough to encourage
investment, creating further employment opportunities. As the dollar has
already appreciated, the interest rate does not need to increase to such a
great extent, especially as this may cause less investment and dampen consumer
spending when it finally seems to have recovered.
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