United States Federal Reserve’s bid to counter inflation could lead to recession

By Yashvardhan Bardoloi

Central banks have to be careful about raising interest rates to counter inflation because it could lead to a recession

By Yashvardhan Bardoloi |

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Of the many stress-inducing questions facing investors and economists in late 2016, one loomed large: when were central banks going to raise interest rates? It wasn’t long before low unemployment and fears about inflation set off a spate of hikes by the US Federal Reserve (Fed) and other central banks.

The question now is how much the rates will rise, and how fast. Attempting to predict anything related to the economy is a perilous task – the late Nobel laureate Paul Samuelson once quipped that “markets have predicted nine out of the past five recessions”.

Why were interest rates near zero in the first place? In response to the global economic crisis, central banks around the world, particularly in developed countries, slashed interest rates to stimulate the economy. This is the standard response to an economic contraction.

Low borrowing costs

The primary intended effect of low interest rates is low borrowing costs. When borrowing money becomes cheaper, businesses see that the return on their investment exceeds the cost of their loan – simply put, investing in the economy becomes more profitable. This creates employment, which also helps to boost spending, and ultimately makes everyone better off.

These interest rate cuts were combined with a series of monetary policies collectively known as quantitative easing (QE). Whereas central banks typically control only short-term rates, QE targeted longer- term yields, helping to further reduce borrowing costs and interest payments on long-term debts such as mortgages. With these measures, the US government tried to spur economic growth through federal spending, particularly job-creating infrastructure projects.

As spending increases, there is the possibility of rising inflation. Prices rise if the rate at which spending is increasing exceeds the rate at which new products are entering the market. The expectation of higher inflation encourages more spending, for fear that people’s purchasing power will erode. All this boosts what economists call “aggregate demand” – essentially, GDP (gross domestic product). Or so it goes in theory.

For years, reality was less than generous to policymakers. The recovery from the crisis was long, but lacklustre. Although unemployment was down, economic growth largely remained tepid. Inflation remained stubbornly low, and instead of investing in the economy, corporations have been sitting on growing piles of cash – essentially an indicator that the perceived rewards from investments do not outweigh the risks.

West’s monetary policies

Against this backdrop, many observers began to criticise the West’s monetary policies. With the Fed once again voting to keep rates near zero towards the end of 2016, some argued that the low interest rate regime should be discontinued.

There were valid arguments to be made that artificially low interest rates may even be exacerbating problems plaguing the economy. Meagre returns on savings mean that future retirees have to put away more today to meet their savings goals. Similar logic applies to companies with pension obligations to meet in the future. The natural consequence of this is less current spending in the economy and depressed growth. The side effects from low interest rates certainly may be potent, but it is unlikely that they overwhelm the substantial incentive to spend engendered by the ability to borrow money nearly for free.

A sudden shock

The global economic situation remains precarious. Inflation is still low, growth is unexceptional, and spending has yet to pick up sufficiently. I wrote in 2016 that a sudden rise in interest rates could jeopardise whatever progress that has been made. This is particularly because the sudden shock to markets grown used to a low interest rate environment could push the global economy back into a recession.

Instead, I wrote then that more fiscal measures may help bolster the economic recovery. Fiscal policy, which entails government measures such as spending programmes and tax cuts, can be unpopular due to its tendency to increase budget deficits. In this low-interest era, borrowing costs for some rich governments are below zero, so there could be no better time to lock in some cheap long-term funding.

Over the past year, inflation has started to pick up, although it remains below the Fed’s target of two per cent in America. The Fed has been gently raising rates, but it should exercise caution in doing

so. Many see the business cycle entering its final stage, and it would be a pity if this gentle expansion over the past decade were to end in a sudden recession because central bankers were too keen on avoiding inflation.

Edited by M.J. Premaratne