By Ismail Ertürk - The Banking Expert at Alliance Manchester Business School, The University of Manchester.
After the 2007 financial crisis that originated in the U.S. the global economy has entered into an anesthetised state as a result of the zero-bound interest rate policy in the U.S. Super low U.S. dollar interest rates enforced by the U.S. Federal Reserve have benefited almost all economies in the world by either stabilising their banking system or stimulating their economy to escape from a highly likely historically significant recession with serious social and political consequences. The ghost of Great Depression of 1929 was regularly invoked to justify the super low U.S. dollar interest rates.
However the economic benefits of zero-bound interest rates came with a cost as cheap and abundant dollar funding in the world have stoked asset bubbles in the US and in emerging economies. Since the summer of 2013 however the US economy no longer needs zero-bound interest rates as the GDP growth and unemployment rate have improved and the banking system has stabilised. Consequently we have seen a divergence of monetary policy needs between the US and the Eurozone and Japan. High interest rates are not in the interest of debt-loaded China either. Realising that the rest of world and the global financial markets are not ready yet for a US dollar interest rate increase the Federal Reserve kept delaying the actual rate increase. But the Federal Reserve kept reminding the markets that the rate rise was not a question of “if” but it was a question of “when”. This communication alone caused major corrections in asset markets especially in emerging economies since the summer of 2013.
The emerging economies like India and Indonesia that were not prepared for a US dollar interest rate increase blamed the US with policy selfishness whereas those emerging economies, like Brazil, that experienced domestic asset bubbles in currencies and stock markets welcomed the correction and currency devaluations. Opinions in the US too are split: the likes of Larry Summers, ex-Treasury Secretary and advisor to Clinton, argue that the US economy has not turned the corner yet and low interest rate policy should continue in a more aggressive way. IMF, too, is worried about the probable damage of high US interest rates on global financial markets and those emerging economies where the private debt levels are high.
But recent further improvements in the unemployment figures in the US seem to have convinced Janet Yellen, the Chairman of the Federal Reserve, the dangers to the US economy in the form of wage-led inflation because of low interest rates are more important. But increasing worries about new bubbles in real estate and stock markets too seem to favour a rate increase.
Then, is the world really ready now to live with the consequences of a rise in the US interest rates? I think the financial world and the debtors in emerging economies have already priced in a US dollar interest rate increase in their pricing of assets and currencies, and the US dollar debt servicing since the tapering tantrum of 2013.
However I am not convinced that even the US economy is ready for an interest rate increase to be able to leave behind the recessionary dangers that the 2007 crisis has sown in the US economy. Of course a symbolic increase of interest rates in magnitudes of single digit basis points is not likely to be a problem. But a quarter per cent increase that we are accustomed to in the past with policy rate increases would damage even the US economy. Let me explain why.
The Federal Reserve uses a state-contingent policy framework in deciding when to increase the interest rates. If the target unemployment level is reached under low interest rates then inflationary pressures become the driver of the interest rate policy. Currently the unemployment rate in the US is 5.5% which means any future growth in the economy would require paying higher wages that can cause inflation. However economics is not like physics and its laws are not universal and timeless.
There are alternative interpretations of current low unemployment and its relation to possible future inflation. The measured unemployment rate is low in the US because a significant number of people who need jobs are no longer looking for jobs because they have given up the hope of finding permanent jobs paying decent wages. This observation is corroborated by the statistics which show the participation rate in the jobs market has fallen in the US- i.e. a smaller percentage of people who can work choose not to work because the prospects are not wonderful. Therefore an increase in interest rates would increase the debt servicing burden of the US households with high levels of debt. Similarly individual private companies too would face higher debt servicing problems. The US government also has significant amount of sovereign debt payments and an increase in interest rates will likely to increase debt servicing levels with highly probable further cutting of welfare spending.
Therefore an increase in the US interest rates as Yellen has announced coming in December, I believe, will reduce consumption by households, reduce investments by the private sector and reduce government spending in the US and thus reduce GDP growth. Increase in the US interest rates will also create uncertainties in the foreign exchange markets and debt servicing ability of emerging economies. Therefore I do not think the US economy itself and the world economy are ready yet for a rate increase. Yellen should not and I do not think she will increase the US dollar interest rates in December.
Ismail Ertürk - The Banking Expert at Alliance Manchester Business School, The University of Manchester.
Ismail is a regular commentator in the broadcast and print media. He has taught corporate finance, bank financial management and international finance on both the School’s MBA and Executive Centre programmes. His research interests are in financialisation and financial innovation.