Tuesday, March 24, 2015

Fed's keeping it cool!

After the last meeting it seems that a rate hike is clearly inevitable. Only the pace of the interest rate hike will be significantly lower than the financial markets initially presumed. This means that it will take some time before the rate in the US is hitting 'normal' levels. For now it's still possible to borrow with these low rates, but due to the stronger dollar it'll probably occur at a much slower pace.

Forced rate

The big question is not only which triggers are required to raise the rate again, but also whether the US economy is strong enough to sustain a high interest rate. Most investors see the very inviting policies of the central banks around the world as the cause of the low interest rates. That's true on one hand. Central banks are indeed forcing a low interest rate with their policy. But the fact that such a large amount of incentives has not led to skyrocketing inflation (yet), seems to puzzle a number of prominent economists.

The 'new normal'   

The low interest rate policy has not only drastically reduced the nominal interest rates, but also the long-term interest rates. In other words, the long term rate corrected for inflation is significantly lower. The only reason why a rate can stay that low is (if the demand as well as the economic output in an economy are that low) when the economic growth and inflation are kept at low levels. This is what some economists, including Lawrence Summers, call the 'new normal'. It is a situation of secular stagnation, in a scenario like that one should settle for low economic growth due to a chronic shortage of demand, and a lack of good investments. This 'new normal' is according to them largely due to aging, lifestyle choices, lower birth rates, a lack of innovation and development capabilities. The low interest rate is therefore a logical consequence of a number of structural factors that the central banks have to carefully deal with. A side effect of low interest rates could be the weakening of the value of a country's own currency. In the short term it may affect the economic growth positively, but happens always at the expense of something else.


Eventually, the interest rate would need to be at a certain 'natural' level, where supply and demand are in balance again. Negative interest rates are needed to even it out in the long run. This period of low interest rates may take longer than anticipated. Economies need to improve fundamentally in order to sustain a higher interest rate. Clear strengthening of investments, consumer spending and the right technology is needed for this. Especially Europe is struggling with this. That justifies the question at what levels the interest rates could be called 'normal' again. The nervousness about the possible timing of an interest rate decision by the Fed still seems quite excessive. Janet Yellen remained cool, and made a smart move by announcing that an interest rate hike is on its way, but the pace will be very slowly. In order to substantiate this statement she reduced her objectives; inflation should still go to two percent, but unemployment should drop towards five percent and wages must continue to rise. This way she keeps all the options on the table, and has not brought too much additional uncertainty to the markets.


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