Risk Attached to Not Raising Interest Rates

There is a risk attached to not raising interest rates. This is rarely mentioned in the continual moaning over the anticipated effects of the Fed raising rates. The Business Standard writes about Fed policy and how the Fed is holding off raising rates because of the Chinese economy.

Janet Yellen’s speech on September 24 at the University of Massachusetts clearly indicated that she and the majority of the members of the Federal Reserve’s Federal Open Market Committee (FOMC) intend to raise the short-term interest rate by the end of 2015.

I was unconvinced. I have believed for some months that the Fed should start tightening monetary policy to reduce the risks of financial instability caused by the behaviour of investors and lenders in response to the prolonged period of exceptionally low interest rates since the 2008 financial crisis. Events in China are no reason for further delay.

The writer notes that employment is about a full as it will get before starting to drive up wages. While low energy prices have kept the overall cost of living down inflation is creeping up everywhere else. There is a risk attached to not raising interest rates and it is in an economy that expects that rates will remain low forever.

Help for the Banks?

Bloomberg Business writes that higher interest rates would be a lifeline to the banks.

Having bailed them out and then helped to repair their balance sheets with record-low interest rates and bond-buying, policy makers may assist the financial industry once more when the U.S. Federal Reserve begins tightening monetary policy.

That’s according to two recently published reports by the Bank for International Settlements and McKinsey & Co., both of which have highlighted the downsides of ultra-easy borrowing costs in the past.

The conclusion drawn by Claudio Borio, the head of the monetary and economic department at the BIS, and colleagues is that the positive impact of being able to earn income by lending money out for higher rates over time is bigger than the hit of defaults and income that doesn’t carry interest.

So, banks will be happy when rates go up. If interest rates go up too high and too fast there is a risk of loan defaults. However, this risk is simply multiplied the longer that the Fed holds off. Risk of not raising interest rates is that it distorts the economic and monetary system.

Risk of another Crash

The International Monetary Fund believes that there is the risk of another crash if interest rates are not kept low according to The Guardian. This is the flip side of the argument about interest rates.

The International Monetary Fund concluded its annual meeting in Lima with a warning to central bankers that the world economy risks another crash unless they continue to support growth with low interest rates.

The Washington-based lender of last resort said in its final communiqué that uncertainty and financial market volatility have increased, and medium-term growth prospects have weakened.

“In many advanced economies, the main risk remains a decline of already low growth,” it said, and this needed to be supported with “continued accommodative monetary policies, and improved financial stability”.

This is the traditional rock versus a hard place dilemma. Global growth is slowing, or reversing in nations like Brazil. Central bankers have finally come around to believe that the US policy in the aftermath of the Great Recession was correct and have lowered rates, printed money as stimulus to their economies and engaged in a Forex Race to the Bottom. The back side of this is the distortion of the financial system brought on by not raising interest rates.