Why the Fed left rates alone

Wednesday, September 30, 2015

By Farrokh Langdana, Director, Executive MBA Program & Professor of Finance and Economics

Faculty Blog: business.rutgers.edu/langdanamacro

On September 17, the Federal Reserve (Fed) decided to keep short-term interest rates near zero, where they have been hovering since 2009. Professor Langdana explores the implications for not raising rates at this time and what might happen when they do go up.

Why did the Fed leave rates alone?

Higher rates dampen capital investment, and hence slow economic growth since they make borrowing more expensive.  This is no time to hit the brakes in the US given our very fledgling "recovery."  And, with confidence (both by consumers and investors) being shaky at best given the global macro-weakness, this was no time to rock the boat.

In addition, we cannot afford the global turmoil that such a rate hike may generate, as in the "Mexican Tequila Effect" which caused unrest in Mexico in the 1990s (read related story in The New York Times: Watching the Fed, and Remembering the Tequila Crisis)

How would a hike affect global/emerging economies?

Capital rushes into a country (A) for three reasons:

  1. Higher interest rates in A.
  2. Safe Haven in A (it is all relative, of course; remember the Cave Theory).
  3. Expected growth in A.

With a rate hike, suddenly all these three factors would light up and turn green for country A. Hot capital would rush out from slower and weaker emerging economies into country A (the US in this case). The exodus of hot capital from emerging economies would drop their supplies of loanable funds and hence push their interest rates up, slowing their economies further.

But wait!  You just wrote that higher interest rates attract capital. Now you write that higher interest rates denude capital! I am confused!

It is indeed confusing; in fact this is known as the Identification Problem in Econometrics. Very simply, higher interest rates caused by an increase in the DEMAND for loanable funds (government borrowing), or in an economy that is safe and on the verge of hopefully growing, will attract capital.  Here high interest rates at home in country A, HAVE CAUSED the capital inflow.

On the other hand, high interest rates caused by an exodus of capital – a decline in the SUPPLY of loanable funds – are a CONSEQUENCE of capital flight. Do not confuse the two radically different scenarios.  If your front door is left open, you cannot tell if someone has just left the house or just entered the house, just by looking at the open door.  Hence, "identification problem."

But then why all this need to raise interest here, maybe now in December? Clearly we are not overheating!

The Fed has created obscene amounts of liquidity since 2008.  Maybe over $3 trillion worth.  All the subprime mess that was bought by Uncle Sam by basically money creation, is still sloshing about.  If the economy were to gain serious traction, and if this vast pool of idle loanable funds were to be borrowed and put into circulation, we would have a sharp inflation problem.

It is the Liquidity Trap that has resulted in low inflation since 2008.  Simply, if consumer and investor confidence is low, the liquidity just sits there; it is not deployed, not borrowed for capital investment.  Ergo, low velocity of money, which translates to low inflation.  Keynes actually described this low-confidence world as an absence of “animal spirits”, without which money would just sit there.

The Fed does not want inflation to be an issue again in the Unites States, nor do I. But the time for decreasing this liquidity is not now.  As St. Augustine, notorious for his philandering, famously prayed to God for Celibacy:  'Please Lord, grant me Celibacy....but not quite yet!"  

'Not quite yet' for rate hikes.

TAGS: Business Insights Economics Executive MBA Farrokh Langdana Finance MBA