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The US has done rather well by following the Bernanke-Yellen line of throwing money at the problem, and it is the first among the major developed economies to emerge from the crisis. Photo: Bloomberg
The US has done rather well by following the Bernanke-Yellen line of throwing money at the problem, and it is the first among the major developed economies to emerge from the crisis. Photo: Bloomberg

Should the US Fed raise rates? IMF and World Bank versus BIS

If after seven years of near zero rates the US economy is still so fragile, does it not raise the question whether something is wrong with the medicine being applied?

Would anyone have foreseen, during the long boom of 2003-07, that the developed economies would be hobbling along on near-zero interest rates from 2008-15? Well, here’s what economist Michal Kalecki wrote as far back as in 1943 in his essay, Political Aspects of Full Employment: “The rate of interest or income tax is reduced in a slump but not increased in the subsequent boom. In this case, the boom will last longer, but it must end in a new slump: one reduction in the rate of interest or income tax does not, of course, eliminate the forces which cause cyclical fluctuations in a capitalist economy. In the new slump, it will be necessary to reduce the rate of interest or income tax again and so on. Thus, in the not too remote future, the rate of interest would have to be negative and income tax would have to be replaced by an income subsidy." That’s a rather apt description of recent monetary policy in the developed economies, at least so far as interest rates are concerned.

So, after seven long years, is it finally time for Janet Yellen to raise interest rates this week? She is under immense pressure not to do so. The International Monetary Fund (IMF) has urged her not to raise rates, at least until next year. World Bank chief economist Kaushik Basu says a rate rise now could cause “panic and turmoil". The markets have had a nervous breakdown at the mere thought of a rate rise.

But there are voices on the other side, too. Peru’s central bank governor has said most emerging markets want the Fed to raise rates as soon as possible to put an end to the uncertainty. And the most authoritative voice that has consistently asked for higher interest rates is the Bank for International Settlements (BIS).

Who is right? The US has done rather well by following the Bernanke-Yellen line of throwing money at the problem, and it is the first among the major developed economies to emerge from the crisis. Growth in the US has come back. Unemployment is low. But the question is: what kind of shape are the US and the world economy in if a mere 25 basis points rate rise could cause so much panic and turmoil? And, if after seven years of near zero rates the US economy is still so fragile, does it not raise the question whether something is wrong with the medicine being applied? One basis point is one-hundredth of a percentage point.

Those who don’t want higher interest rates say there’s no reason to do so because inflation is low. Chris Williamson, chief economist with Markit, wrote after a good August Purchasing Managers’ Index (PMI) print that while the growth momentum remains intact in the US economy, inflationary pressures have abated, which bolsters the argument for delaying interest rate hikes. He says the PMI survey data show that the average selling prices for goods and services in the US have fallen in August for the first time since 2010.

Finally, there’s the argument that the markets are currently unstable, with China emerging as a major uncertainty and with most emerging markets and commodity exporters crumbling. Higher asset prices have always been an objective of monetary policy in the US, intent as they are on stoking the wealth effect. Why rock the boat, especially when it is sailing in turbulent waters?

If inflation is not a problem at the moment, thanks to lower oil and commodity prices, what’s the hurry to raise rates? This is precisely the reasoning that led Alan Greenspan to keep monetary policy loose, because globalization had led to low inflation. We all know how that ended. The BIS says that central banks’ focus on near-term inflation has led them to loosen monetary policy rapidly during busts and not tighten them much during booms. That asset prices are high and can go even higher with a sluggish real economy and money sloshing around doesn’t seem to count.

A BIS study has found that the effect of monetary policy rates on asset prices has been growing since the mid-1980s, following financial liberalization. Also, after taking into account the effect on credit and property prices, monetary policy has had a reduced effect on output. In other words, the study shows that a monetary policy focused on managing near-term inflation and output may do so at the cost of higher fluctuations in credit and asset prices. The easing bias of central banks allows financial booms to grow bigger, last longer and collapse more violently.

Then there’s the effect of the misallocation of resources in the real economy as a result of easy monetary policy. The BIS estimates that as a result of loose monetary policy in 2004-07, annual labour productivity growth was lower by around 0.2 percentage point in the US, 0.4 percentage point in Italy, around 0.7 percentage point in Spain and around 1 percentage point in Ireland, compared with a counterfactual in which credit to gross domestic product, or GDP, grew at its 1994-2004 average.

But perhaps the clinching argument is that the developed economies seem to have no other plan but to revive the earlier model of debt-fuelled growth. Says the BIS: “The policy mix has relied too much on measures that, directly or indirectly, have entrenched dependence on the very debt-fuelled growth model that lay at the root of the crisis. These tensions manifest themselves most visibly in the failure of global debt burdens to adjust, the continued decline in productivity growth and, above all, the progressive loss of policy room for manoeuvre, both fiscal and monetary."

Manas Chakravarty looks at trends and issues in the financial markets. Your comments are welcome at capitalaccount@livemint.com

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