After keeping interest rates at close to zero for several years, the US Federal Reserve has moved to finally increase interest rates. This increase in interest rates is more significant than usual because it marks an end to the unique circumstance of ultra-low interest rates. The Federal Reserve has also indicated they expect to raise interest rates three times throughout 2017.
The impact of increasing interest rates
I have covered this in detail before, so I won’t repeat too much here. See: Impact of raising interest rates, but to summarise:
- Higher borrowing costs for firms, consumers and government.
- Improved returns on savings
- Appreciation in the dollar due to hot money flows.
- Likely deterioration in trade balance as US exports more expensive.
More interesting is what will be the significance for the US and global economy, given this particular increase?
- Consumers have got used to very low-interest rates.
Mortgage and credit card payments are historically very low. Young adults will have forgotten periods in the 80s and 90s when interest rates were in double figures. Very low-interest rates have encouraged people to take on debt assuming, perhaps, interest rates would remain low.
According to TransUnion, around 92 million US consumers have taken out loans on variable rates. The increase in federal rates will on average, increase monthly payments $6.45 per month. In the last year, the fastest growing area of credit card debt was the sub-prime market (15% growth in Q3). (Source: FT)
This group of subprime borrowers will be most at risk from rising interest rates. There are fears of rising delinquency rates in 2017, as further rises feed through into higher debt payments.
Saving rates still stuck
The rise in interest rates may sound good news for ‘long-suffering savers’ but, so far, banks are not keen to raise deposit rates. Most banks are planning to increase loan rates from 3.5% to 3.75%, but deposit rates will be unchanged. Banks will be relieved to see rising interest rates as a way to try and improve profitability – profitability which has been hit by the period of ultra-low rates.
The significance of the rise in US interest rates is that the US is the first major economy to move away from the interest rate floor of 0.5% Europe, UK and Japan are still grasping with their comparatively sluggish recovery. This means the US could see a sharp rise in demand for dollar assets – pushing the US dollar higher. Already, the Euro has fallen to a 14 year low against the US Dollar. The weakness of the Euro will help improve EU competitiveness and provide a welcome boost to EU growth – through trade to the US is only a small share of the EU economy.
Dollar denominated debt
Many emerging markets have borrowed in dollars. The appreciation in the dollar will increase the cost of dollar repayments; this will increase the share of debt paid for by emerging economies.
Impact on China
The rise in US interest rates could increase the flow of Chinese financial assets out of China, causing a further weakening of the Yuan. Some analysts are concerned the Chinese economy is vulnerable to a boom and bust situation, with rising debt levels – this makes US a relative safe haven and attractive place for deposits.
On the other hand, the appreciation of the dollar will make Chinese exports even more competitive, boosting export demand and growth. It is not certain whether the Chinese economy would benefit from the stimulus of a depreciation or whether the inflationary effects would be harmful.
Uncertainty of US fiscal and trade policy
One uncertainty of the rise in interest rates is what will happen to US fiscal and trade policy.
An appreciation of the dollar will put pressure on US exporters. This pressure could encourage Donald Trump to pursue more protectionist measures against China, which would also lead to retaliation (see: impact of US tariffs)
The other uncertainty is fiscal policy. In theory, the US could see a strong expansionary fiscal policy with tax cuts (mostly for wealthy) and higher government spending. This would be inflationary and increase the pressure on the Federal Reserve to increase rates faster. This combination of expansionary fiscal policy and tightening of monetary policy could see strong consumer demand, but exporters squeezed by the strong dollar.
Another uncertainty is the future direction of the global economy. Will the Eurozone catch up with the US economy and also break out of near-zero interest rates? Despite recent improvements, European unemployment rates are over twice as high.
Too early to raise interest rates?
Not everyone is bullish about the economy and supportive of higher rates. Skeptics point to the fact inflation is still below 2% (1.6) and structural weaknesses in the economy, could make firms and consumers vulnerable to rising rates. For example, Paul Krugman argues it is better to err on the side of allowing too much inflation – than too little. The logic is that if inflation gets too high, it is relatively easy to reduce it through monetary tightening. But, if the recovery is snuffed out, there is less room for manoeuvre on the expansionary side.