Avoiding the stagnation equilibrium - J.P. Morgan Asset Management

Avoiding the stagnation equilibrium

Contributors Dr. David Kelly, Global Markets Insights Strategy Team
In brief
  • It is commonly assumed that when the Federal Reserve (Fed) begins to raise short-term interest rates from near-zero levels, their actions will slow the economy.
  • We believe this is wrong, that the relationship between short-term interest rates and aggregate demand is non-linear, and that the first few rate hikes would actually boost aggregate demand, although further hikes from a higher level could reduce it.
  • To show this, we look at six broad effects of raising short-term interest rates: an income effect, a price effect, a wealth effect, an exchange rate effect, an expectations effect and a confidence effect.
  • This analysis suggests that the Fed should, belatedly, begin to raise rates now, not because the economy is strong enough to take the hit, but rather because it is weak enough to welcome the help.

At their September meeting, the Fed decided, for the 54th consecutive time, to leave short-term interest rates unchanged at a near-zero level. While only one voting member of the Federal Open Market Committee (FOMC) dissented, the Fed’s action, or rather inaction, was hotly debated.

Those advocating an immediate hike argued that the economy had progressed far beyond the emergency conditions that had led to the imposition of a zero interest rate policy in the first place and that the Fed was already dangerously “behind the curve.” Those lobbying for further delay pointed to a lack of wage inflation and signs of weakness in the global economy.

However, frustratingly, we believe this argument, like all monetary policy debates in recent years, has been waged on a false premise, namely that increasing short-term interest rates, even from these extraordinarily low levels, would hurt aggregate demand. We believe that the opposite is true. The real-world relationship between interest rates and aggregate demand is non-linear and an examination of the transmission mechanisms suggest that the first few rate hikes, far from depressing aggregate demand, would actually boost it.

Raising short-term rates from near zero should boost economic demand, although raising rates from higher levels could reduce it
Exhibit 1: Non-linear relationship between short-term interest rates and output

Source: J.P. Morgan Asset Management; data as of 13 October 2015. The chart above and the charts, graphs and tables herein are for illustrative purposes only.

The true relationship may, in fact, be as portrayed in Exhibit 1. As we outline in the pages that follow, raising short-term interest rates from very low levels could actually increase aggregate demand as positive income, wealth, expectations and confidence effects outweigh relatively innocuous negative price effects and ambiguous exchange rate effects. However, as interest rates increase further, the price effects of rate increases become more damaging while wealth, expectations and confidence effects eventually turn negative, causing rate increases to drag on economic demand. In other words, monetary tightening from super-easy levels can actually accelerate the economy beyond its potential growth rate before slowing it, ideally to a soft landing at a higher level of output and interest rates.

There is, of course, more to the story. All of these effects have changed over the decades so that this argument might not have been as strong had a zero interest rate policy been employed, say, in the 1960s. In addition, the impact of interest rates on the economy is asymmetric — a cut in interest rates from a normal level that had been sustained for some time might well boost demand even if an increase to that level didn’t dampen it. Finally, on the supply side, there is likely a significant long-term cost in lost economic efficiency from holding the price of money at an artificially low level. All of these issues are worth further research. However, for the Fed, the basic point is the most important one. The reason it should have raised rates in September and the reason, failing that, that it should do so this month isn’t that the economy can handle the pain but rather that it could do with the help.

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Avoiding the stagnation equilibrium