Interest rates are likely to rise this year. The Bank of England could raise them for a second time since December next month, and the Fed is expected to hike in March. This raises three unpleasant truths.
First, higher interest rates cut inflation by inflicting pain. In raising the cost of credit they reduce not just consumer spending but companies’ demand for labour. “Monetary policy tightenings raise unemployment” concluded the Bank of England’s Gregory Thwaites and colleagues in one study of their effects. In 1989 then chancellor John Major said of high interest rates “if the policy isn't hurting, it isn't working.” That was good economics, if too honest.
Secondly, the hurt can be global and fall upon the most vulnerable. One channel through which higher rates reduce inflation is by raising the exchange rate, thereby cutting import prices. A stronger dollar, however, is nasty for many emerging markets. It raises the cost of servicing dollar-denominated debts, and also the local-currency cost of those raw materials that are priced in dollars. It’s sometimes said that ultra-low interest rates benefit the rich by supporting asset prices. That’s only part of the story. They also help low-wage workers in poor countries. Higher rates withdraw such help.
Thirdly, nobody knows the precise effects of higher official interest rates.
One reason for this is that these effects depend upon how such rises affect the cost of borrowing for individuals and companies. These costs – such as mortgage rates – also depend upon longer-term bond yields which in turn depend upon expectations of the longer-term path of official rates: the more these expectations rise, the greater will be the increase in the cost of borrowing. Nobody can say with confidence, however, what the impact upon expectations will be.
A second reason is that higher interest rates work by reducing asset prices: the higher is the return on cash, the lower will be demand for bonds and equities. But this raises two uncertainties. One is how much higher rates will hurt shares. The impact could be big, if the “reach for yield” goes into sharp reverse, or if superstar stocks sell off because of their sensitivity to bonds yields, as Princeton University’s Atif Mian and colleagues have shown. The second uncertainty is how much falling share prices would curb demand in the real economy. This is tricky as it is difficult to measure wealth effects precisely.
Economists’ least-bad estimation is that the impact of higher rates is modest. Bank of England economists have estimated that a one percentage point increase in Bank rate reduces inflation “by up to one percentage point after two to three years”. Which isn’t very much. One reason why it’s not is that higher rates don’t affect some prices: they’ll do nothing to increase the supply of gas or computer chips, shortages of which have added to inflation recently. Also, for millions of cash savers higher interest rates mean higher incomes. That partly offsets the blow to demand caused by higher borrowing costs.
That estimate is, however, an average – and there is variation around averages.
All this explains why the Fed especially has been so slow to raise rates. It doesn’t want to inflict pain on workers and companies (including those outside the US) especially when it doesn’t know just how much pain there’ll be. And for this same reason, both the Fed and Bank of England are likely to raise rates only slowly. Positive real interest rates – let alone high ones – are some way off.