Almost 10 years ago, the world economies entered into a dangerous phase of prolonged recessions that threatened the well-being of many families, saw unemployment rising and economic growth disappearing. Politicians relied mainly on central bankers to use monetary policy to stimulate the economies and avert the prospect of depression that was becoming more likely.
The favourite tool of the Federal Reserve as well as that of the European Central Bank was to reduce interest rates and increase liquidity to avoid a collapse of financial markets. This helped governments in distress to sell their debt and avoid bankruptcy. It also helped businesses to borrow money at very low interest rates, thereby helping stimulate economic growth and job creation.
When, in the middle of this month, the Federal Reserve increased interest rates by 0.25 per cent there was no surprise in financial markets. The era of cheap money was coming to an end.
The US economy continues to show signs of growth while unemployment is decreasing. Unfortunately, in Europe the prospects are less encouraging as most EU economies continue to struggle and unemployment remains uncomfortably high. So the US and the EU economies are moving on different tracks with the US economy once again proving to be far more resilient than that of the EU.
While a rise in interest rates will have an effect both on households and on the real economy, many economists agree that it is hard to predict the likely effect of higher interest rates in the US and, eventually, in the EU. Raising rates modestly for the first time in almost a decade is the easy part. Now comes the challenging part: will the US economy, and, eventually, that of the EU, be able to cope and revert to significant growth?
Interest rates hikes take time to percolate through the real economy and central bankers have to be vigilant to ensure that, once they see signs of economic weakening, they will revert to corrective action.
In the short term, the threats the world economies are facing are not so much modest interest rate hikes but, rather, geopolitical problems and a rise in populist political initiatives that can only give rise to more uncertainty.
EU leaders have much more pressing problems to deal with in 2016 than worry about when it will be ideal to raise interest rates. The governance of the EU will be shaken even more if, as happened in Spain, some member countries will find it that much more difficult to have a stable government as fringe parties of the right and the left hold the balance of power in national elections.
The strengthening of the US economy combined with the interest rate rise will likely result in a stronger dollar and a weaker euro. This could be good news for EU-based exporters as the weak euro will give them a competitive advantage. To what extent this will affect US exporters remains to be seen but, as long as the greenback does not appreciate substantially, many economists predict minor effects on US competitiveness.
At the micro economic level, an EU interest rate hike will impact everyone who has a mortgage, car loan or a savings account. Low interest rates are good for borrowers but bad for savers.
As long as interest rate increases in the US and the EU are gradual, it would be a good thing to exit this extraordinary phase of cheap money that does not encourage sustainable long-term economic growth.