In December, the Federal Reserve of the United States raised interest for the first time in nearly 10 years. Interest rates in the US have been zero for seven years. The cost of money has now risen to 0.25 per cent – still very low whichever way one looks at it. However, this does not mean that such a rise will not bring challenges.
One cannot help asking whether this was the right moment to raise interest rates and what effects there will be on the economy (not just the US economy but also other leading economies).
What is expected to happen in 2016? Maybe these questions show that we got used to low interest rates and so the first increase in nearly a decade has been a big shock, even if many analysts expected it.
These questions also reflect that the US economy has generally set the pace for the world economy and US interest rates have an impact on the value of the dollar, which is used as peg by a number of other economies.
Still, we are talking of an increase of 0.25 per cent. There are some who consider this increase to be minimal. They refer to the days in the 1980s when the Federal Reserve raised rates from 11 per cent to over 20 per cent to address inflation that had reached double digit figures. So an increase of a quarter of one per cent may seem like an irrelevant detail.
Interest rates are just a tool and should be considered as such
On the other hand, there are those who feel that the economic recovery is still quite fragile and even such a minor increase will have a direct impact on consumer purchasing power, and may prove to have been an untimely decision. Yet, this decision has been expected for quite some time and as the chairwoman of the Federal Reserve, Janet Yellen, stated it could not be delayed any longer.
The fear of negative consequences remains, in spite of the fact that unemployment in the US has been halved and there has been growth in the gross domestic product for a number of years. Moreover, the need to normalise matters in the financial markets has been felt for quite some time. Although we may have got used to zero interest rates, the massive monetary stimulus used to prop up the economy after the collapse of Lehman Brothers and the bailout of a number of banks at advantageous conditions, could not be sustained and could not be considered as normal.
The fear of negative consequences is also quite real and is based on important consequences. One needs to keep in mind that, like any other central bank, the Federal Reserve has two main functions: to maximise employment and to keep inflation under control.
It is true that unemployment in the United States has gone down – but how have wages behaved? How much of the increase in employment is due to an increase in part-time employment and to lower wages? How much is the decrease in unemployment due to persons leaving the labour market?
Inflation is still under one per cent and with the fall in the price of oil and the readjustment in the Chinese economy, prudence seems to be called for.
Nearly a month has passed since the Federal Reserve increased interest rates. The Christmas period may have not allowed matters to take their normal course and some of the effects are still to be felt. This would mean that it may still be too early to determine whether the Federal Reserve’s decision was the right one or not.
Yellen, when announcing the decision, promised that she would move gradually, gauging the impact of each decision she takes before embarking on the next one. One should also remember that this is election year in the United States and the Federal Reserve (in spite of its independence) would want to make sure that it does not rock the boat unduly. Thus, it is also difficlut to predict whether there will be further increases in interest rates in the US in 2016.
It is also worth asking whether the Bank of England will follow suit and how the US decision will affect the Chinese and eurozone economies, considering that the latter is also going through a quantitative easing programme.
Governments around the world, businesses and financial markets all hope to have more clarity over the coming weeks. In any case we must keep in mind one fundamental principle – it is what happens in the real economy that creates growth and one’s focus should remain on the real economy. Interest rates are just a tool and should be considered as such.