Avoiding the stagnation equilibriumContributors Dr. David Kelly, Global Markets Insights Strategy Team
- 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