Should Yellen go for a rate hike in March 2017?

This article was first published on my LinkedIn profile.

Fiscal and monetary policies are tools used by governments and central banks, respectively, to smooth out the bumps in the business cycle (booms and bursts).

U.S. monetary policy before the crisis of 2008

Prior to the financial crisis of 2008, Federal Reserve, the U.S. central bank followed the conventional monetary policy under which a central bank increases the benchmark rate during high inflation and reduces the benchmark rate when inflation comes under control.

Can a central bank take a rigid stand and refuse to reduce the interest rate despite inflation coming under control?

Yes, a central bank might take a rigid stand. A non-accommodative monetary policy can impact a country’s fiscal policy. In May 2016, Subramanian Swamy had accused Raghuram Rajan, the then RBI Governor of India of taking a rigid stand by not reducing the interest rates despite the inflation being under control.

U.S. Monetary Policy after the financial crisis of 2008 

Post the 2008 financial crisis, FED slashed its benchmark interest dramatically and kept it at near zero levels till December 2015!

This means that the citizens of U.S. received near zero levels of interest on their savings with the banks for seven years! Finally, the FED raised the benchmark rates in December 2015 to a range of 0.25-0.50%.

Why did FED slash the interest rates to near zero levels?

  • Low interest rate would reduce the borrowing cost of commercial banks (CBs). Thus the CBs would tend to lend more.
  • Cheaper loans would result in more business activities which would in turn boost production.
  • Increased production would lead to job creation and ultimately the economy would be pulled out of the economic recession.

Are there any side effects of such ‘easy money’ policy?

  • Zero interest rate on savings deposit pinches savers.
  • It also leads to asset price bubbles.
  • Low interest rates in the U.S., Japan, and U.K. have flooded the emerging markets such as India with hot money. Such hot money inflates the stock prices in such markets (bubble).
  • The problem arises when such economies withdraw their monetary stimulus program and start tightening their monetary policy. It leads to flight of capital back to the developed markets (the bubble gets pricked!).

Should the FED go for a rate hike in March 2017?

There are experts who argue that FED should be very cautious with a rate hike at this juncture because the economic recovery in the U.S. is still fragile. They argue that a rate hike at this point may lead to a credit crunch (as borrowing would become costlier) and that may derail the economic recovery.

But that’s not true!

When a central bank raises the short term interest rate from very low level, it actually acts as a stimulant!

The rising interest rates will have a tightening effect (credit crunch) only after a couple of interest rate hikes.

How would a rate hike act as a stimulant?

A rate hike in U.S. at present would lead to four positive effects on the economy.

1.   A positive income effect: a rate hike at present would give a big boost to the household savings. According to JP Morgan, a rate hike of 25bps points at present would pump about USD 65 billion in the hands of the U.S. households in the form of income from savings deposit. This would be a big boost for the consumer goods industry in the U.S.

2.   A confidence effect: When FED raises interest rate, people would feel more confident about the economic recovery which in turn may lead to increase in productivity.

3.   A positive expectations effect: If FED raises the interest rate in March, people may assume that the economy is recovering and FED would continue to raise the interest rates in future. Hence, people may start borrowing more and more at present (borrow now to buy your dream home/car when it’s cheaper!). This might again act as a stimulant for the economy.

4.   A positive wealth effect: When rates rise from a low level, investors may feel confident about the recovery and that confidence may transcend into the stock market.

The problem with the U.S. monetary policy explained with the help of an example:

A patient suffering from acute headache goes to a doctor. The doctor advises him to take a pain killer every day till the problem persists.

The patient starts taking 2-3 pain killers every day. He feels better but he gradually increases the dosage to 10-12 painkillers every day believing that high doses would cure him forever!

If 2 painkillers are good for you, it doesn’t means that 12 painkillers are also good for you!

Similarly, extra-ordinary monetary stimulus in the form negative interest rates, helicopter money and quantitative easing does not necessarily helps an economy!

 

 

This article is strictly meant for educational purpose and it may be of interest to researchers as well as students. The Astute Investor acknowledges the fact that a couple of estimates/figures provided in this report have been sourced from various financial news websites (Reuters, Money Control, 4-traders) and research reports available in the public domain.

 

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