Yellen’s announcement may be the much-needed respite from the maelstrom of low growth for the US.
A rate hike has become equivalent to a much-needed pull to the system. Interest rates saw a change first in 2009. Yellen’s announcement of a rise in the benchmark interest rate by 25 basis points, seemed like a Holiday bonanza. The announcement comes with reasons that are multi-faceted. Trump’s administration has promised adequate fiscal stimulus, to begin with. Next, a promising labour market growth and the proposed investments in infrastructure have made economic forecasts favourable for the medium-term. These reasons aside, there is always the trade-off between inflation and economic growth that the central bank is trying to achieve. To aid the announcement, the inflation rate has been below the targeted 2 percent.
At this juncture, investors and concerned parties are worried about two issues: the snail’s pace of the Fed about interest rates, and the inflation rate. The financial crisis has left a lot of investors worrying that low interest rates are here to stay. Low interest rates in the economy may do good in the short term, but they provide no foreseeable benefits to an open economy. Back in 2009, when the Fed cut interest rates to near zero, it was a step to counter low economic growth. However, this sort of backfired at the time, leading to the natural interest rate becoming lower than the real rate, leading to tighter monetary conditions, and even lower economic activity. Infact, this may also be the reason for inflation still being below the target.
It all started in 2007, when BNP Paribas withdrew a large chunk of investments in the subprime scenario. Open market operations reduced the interest rates from 5.25 percent to a lower bound in the range of 0 to 25 basis points, till 2015. What followed were large-scale asset purchases and drastic reduction in their yields. Since then, interest rate management has been dependent on more than just inflation rate; savings and investment fundamentals propelled by demand and supply of capital, and consequently lower growth have assisted in pegging interest rates. The converse of this has also been true: investors have become more risk averse, and have preferred investing in safer assets. This scenario has been further supported by the banking crisis, and volatility in the housing industry, following the financial crisis. In addition to this, pre- and post-recession output gaps tend to be permanent and more damaging, and affect growth in the long run. One of the effects of all the asset purchases was increase in security holdings; reserves had become a liability, by rising 5.5 times their pre-purchase balances. And with the Fed paying interest on the existing reserves and excess reserves, and gaining from arbitrage in interest rates from the market, raising interest rates has become an extremely cautionary process.
Specifically, therefore, it is better to consider interest rate and monetary policy together; weaker demand and lower output have been indicators of financial crisis since 2007-08. When short term interest rates are adjusted, it is done so with the view that variables like wages, employment rates and prices will adjust to give momentum to new economic activity. But again, a change in inflation rate would occur if there are shocks in the form of dynamic oil prices or political changes. This would in turn encourage output gaps and perpetrate inflation. This situation has not yet changed completely. To reach a near-ideal situation of strong output growth and favourable interest rates within the targeted inflation rate, interest rates must be accommodative, and must also consider decreasing the output gap. Currently, with output that is below potential and with interest rates that are dragging the economy further down, gradual hikes in interest rates seem the best solution.