The interest rate predicament

Interest rates are the primary tool in Central Banks toolkit to bounce back from recessions. As far back as the data goes, the US Fed has always lowered interest rates during recessions.

One of our managers recently said they believe Janet Yellen (Chair of the US FED) has the worst job in the world. Whilst this was a slight exaggeration, it does have some merit. The US Fed, along with Central Banks around the world, have a large predicament. Specifically, an interest rate predicament.

The theory being:
cheaper money = population borrow more = population spend more = stimulated economy

US Federal funds interest rates

This theory was in full effect in the 2008 recession (GFC), where the US rates fell from over 5% to effectively 0%. And it worked to a large degree, the economy did bounce back. However, unlike previous recoveries, interest rates did not bounce back in the subsequent recovery.

So the best tool that Central Banks have to fight recessions is to lower interest rates. And interest rates are already at historic lows? Here lies the predicament.

Janet Yellen realises this, of course, and would like to raise interest rates but has been held back due to fragility of the global economy. The FED had its first interest rate increase in over 10 years back in December 2015 (0.00% to 0.25%). Despite many promises, we are yet to see another interest rate hike in 2016.

If another recession is around the corner, investors won’t be able to rely on interest rate cuts for another rescue.

7 November, 2016 – Dan Jenkins is NZAM’s Business Analyst.

Disclaimer:

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