The Prospect of Raising

The decision on interest rates marks a crucial phase in economics.

In the meeting that is to take place on the 20-21st of September, the Fed will decide about raising interest rates or otherwise. Meanwhile, several economists and strategists opine about the situation and as to what warrants an increase or the status quo. Low interest rates, especially since the financial crisis of 2007-08, have raised a doubt whether such low rates are here to stay. Secular stagnation has also been an explanation to the phenomenon. The reasons cited for raising the interest rates were – reaching the inflation target, and maximising the employment rate. A recovering labor market and an improvement in economic activity seem to offer causal support. In August this year, Janet Yellen hinted at raising interest rates sooner rather than later, given that increase in consumer spending was revised from 4.2 to 4.4 percent. The actual consumer spending increased from 0.41 percent to 1.07 percent in the 2nd quarter (see graph).

A lower bound interest rate scenario may be something that is challenging for monetary policy design, and future anticipations of the same. Targeting an inflation rate that is reasonable in the medium term may be a reliable method to maintain central bank credibility. Large-scale asset purchase programs and forward guidance may be some more methods to pacify investors and combat lower bound interest rates.

However, one is more concerned about short-term real interest rate. This rate is determined by the rate of savings and investments in the economy. This is precisely why economic activity is an important indicator when interest rates are to be decided upon. Weak aggregate demand, slowing down of productivity, and an aging population have been cited as other main reasons. In the recent months, this short-term rate has been observed to influence the longer-term rate as well, not just in the US, but other economies too.

This reflects that it is also necessary to consider the financial cycle and essentially financial developments. One of the effects that occurs on production is that of the financial cycle.  Considering financial booms as well as busts to record interest rate movements, and ambitiously considering raising the equilibrium real rate of interest. This would nevertheless require creating demand in terms of more investment in technology, innovation, entrepreneurship, and education. The demand created thus, would help kick-start the economy in certain ways, and help in rebuilding aggregate demand, and reach the target inflation in the short-run. The decision about interest rates is a challenging debacle and will decide the future of international economics in more ways than one.

 

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