Federal Reserve Chairman Ben Bernanke recently announced the Fed’s intention of keeping interest rates at today’s ultra-low levels until 2014. This expected announcement was in line with Fed policy of the past 6 years. However, the question facing us today is for how much longer will such unprecedented rates continue to skim these low depths? What does it augur for the economy? How will the common man on the street be affected?
Low Interest Rates: How Crucial is it for the Economy’s Fortunes?
To know the answer, we will have to turn back the hands of the clock and examine a chain of unprecedented events that took place almost all over the world in 2007. Some of these events were triggered by some executives on Wall Street who were bundling and rebundling worthless mortgages along with too many people who were able to buy a home without being asked for any type of down payment.
It is widely held that the 2007 recession continues even until today, being the most intense that the world has witnessed since the Great Depression. Extraordinary situations merit extraordinary actions and to combat this financial crisis that threatened to snowball into a debacle, the Fed stepped in. The Fed is doing all that it can do to keep the economy from actually shrinking.
Probably the most crucial step the Fed took to stabilize a rocky U.S. economy was to slash short-term interest rates to almost nil. This was done by reducing the federal funds rate, thereby encouraging banks to advance more loans to spending hungry businesses and households.
This was followed by the policy of Quantitative Easing (QE) designed to pump up the supply of money in the economy. Quantitative Easing made more funds available for bank loans to businesses and to the man in the street. The Fed bought long-term Treasury and mortgage-backed securities from banks, thereby helping the banks to clear their debts. In the long run, this increased liquidity may very well undermine value of the dollar and hit America very hard. However for the time being, the economy is not being blasted with the onslaught of inflation.
There is no disputing that today the economy has recovered to the point of stagnancy which is after all better than shrinking. It has shown some resilience even in the face of the European debt crisis. American prices are stable and it is true that employment figures have improved just a little bit. However, employment is still well above the 5% level where we would have expected it to be by this time.
“Compound interest is the most powerful force in the Universe.” – Albert Einstein
Low Interest Rates: Can they Last Forever?
It seems that if the Fed has its way, interest rates will continue at these historic lows for a great length of time. After all, borrowers are not complaining and you have to admit that these low interest rates almost single-handedly prevented the economy from declining further into the doldrums. The Fed has limitless powers to create money, boost bank reserves, and thus control interest rates.
The failure of the German bond auction spiked interest rates in that country. The Japanese government too had to raise rates after keeping them to almost nil for a decade. All the more ironic considering that these countries were once regarded as “safe havens.” So, it is just a matter of time before U.S. policymakers realize that artificially keeping interest rates low will spike inflation in the long run and wreck further havoc with the savings of the people. This is a natural outcome for today’s America that habitually spends more money than it has. In fact and moreover, the Fed is already under considerable pressure to cut back on its credit-easing and stimulus spending policies, which many quarters believe has contributed significantly to the country’s staggering budget deficit.
It is just a matter of time.
How Will High Interest Rates Affect the Economy?
So, now that the inevitable has been stated, it is time to ponder on how will high interest rates affect the economy.
The most immediate effect of higher interest rates is felt by borrowers. With an increase in the cost of borrowing, individuals and businesses are compelled to cut down on consumption and put on hold their expansion plans. The monthly payments on a home mortgage will increase and people feel a heavy tug at their disposable incomes. This leads to further consumer spending cuts.
Reduction in consumer spending affects industries and sectors across the economy. Increased rates make it difficult for businesses and especially start-ups, to realize their expansion plans. This in turn, causes an increase in unemployment. Simply put, many people will lose their jobs. A spike in interest rates encourages saving money instead of spending. Company sales decrease and so do jobs.
It has been quite some time since the interest rates had been reduced so low and for so long. The honeymoon period may be over soon and the ensuing reality will be stark.