US interest rates keep creeping upwards, largely because the US Federal Reserve (Fed) is expected to ramp up borrowings costs further in the coming quarters. The Federal Funds Rate is now in a bandwidth of 1.75 to 2.0 per cent, and the yield on 10-year Treasuries has recently climbed slightly above the 3 per cent level. Higher, let alone further rising, borrowing costs can be expected to have far-reaching consequences for the economy and financial markets in particular.
This becomes clear if we reflect upon the Fed’s interest rate policy by employing sound economic theory. Let us therefore begin with highlighting five effects that result from the Fed lowering market interest rates – by slashing its Federal Funds Rate and/or by bidding up bond prices and thus suppressing capital market yields across the board. For this should help us better understand what the Fed’s current tightening of monetary policy might hold in store.
Effects of interest rate manipulation
1.) The artificially suppressed interest rate induces an unsustainable boom: It discourages savings and encourages consumption and investment, thereby seducing the economy to live beyond its means. Firms hire new staff, increase their production facilities, pay higher wages – and the economy expands.
2.) The forced depression of the interest rate makes firms more likely to engage in
long-term investments, which become more profitable as interest rate declines. The overall production and employment structure of the economy gets distorted: Scarce resources are increasingly lured into the capital goods industries, drawn away from the consumer goods industry.
3.) The artificial decline in interest rates inflates stock and housing prices: Future cash flows are discounted at a lower interest rate, thereby increasing their present value and, as a result, their market price. Exceptionally low interest rates also contribute to increasing valuation levels of asset markets – meaning that, for example, stocks and housing become more expensive relative to the incomes they generate.
