Interest Rates 101: How a hike may change U.S., global economies

Scott Anderson
Posted by Scott Anderson
Chief Economist

As the Federal Reserve prepares to start raising interest rates, perhaps by year’s end, Bank of the West Chief Economist Scott Anderson, PhD, answered questions from our editorial staff to help demystify rising rates. The resulting three-part “Interest Rates 101” series looks at what the rate-hike process — or “normalization” of interest rates — could mean for consumers, businesses, exporters, and the U.S. and global economies.

In this first segment, Scott addresses the possible implications for the U.S. and global economies.

Q: First of all, why do rates need to rise?

Flat sunrise horizon with clouds above in the shape of all the continents on the global map.The Federal Reserve has a dual mandate: Maintain full employment and stable prices. The Fed is very close to achieving its goal on full employment and anticipates that it will be in a position to reach its goal on stable inflation before too long. So Fed policy makers believe the period of emergency monetary policy where interest rates are at zero is no longer appropriate, and the economy can handle a more normal interest-rate environment, which probably means higher short-term and long-term interest rates ahead.

The Fed is always looking six months to two years down the road, and they basically want to head off a potential inflationary event in the future.

What will rising rates mean for the U.S. economy and the global economy?

It shouldn’t be a huge problem for the U.S. economy to digest gradually rising interest rates. We don’t really expect any major negative consequences on the housing market, for example, because the job market is picking up. Wages are increasing. Those factors will support the economy even as the Fed starts to raise interest rates.

In terms of the rest of the world, it’s going to create a little bit of volatility as we’re already seeing in the markets — particularly for emerging markets that have seen a lot of capital flowing out of their economies. The Federal Reserve raising interest rates is a signal to investors that the U.S. economy is back on track, and so you’re going to see upward pressure on the U.S. dollar and capital outflows from emerging markets.

It’s a little bit of déjà vu. You think back to the late 1990s. The Asian financial crisis was a time when the Fed was raising interest rates, and we saw severe currency declines, capital outflows, and financial crises in several Asian countries. We don’t think we’re going to see things that negative this time, but it’s certainly creating a lot of uncertainty right now as money moves around.

What could go wrong, either domestically or globally, with rising rates in the United States?

Well, a lot of people are concerned that the Fed’s going to move too aggressively here; that not only is it going to raise interest rates in September, but it’s going to keep raising them, maybe in December and maybe four more times next year. There are concerns that the U.S. economy can’t bear those sorts of increases given the fact that people have gotten used to low borrowing costs.

Graph showing the Fed funds rate (%) over 3 decades.So what kind of shock is it going to be if borrowing costs are a percentage-point higher 12 months from now? There are also concerns that this could increase upward pressure on the U.S. dollar, push commodity prices and inflation even lower. We’re seeing big sell-offs these days in crude oil. We’re seeing import prices declining because of the strong dollar. All those things could push down consumer inflation even further and keep the Fed further away from their inflation targets.

I think the Fed really does want to normalize rates, but it’s going to be a kind of “two steps forward, one step back” approach, and it’s going to be much slower than we’ve seen in the past. They’ve been signaling that, and I even think they’re going to be a little bit slower than what the Fed even anticipated back in June, because we’re moving in a different direction than all the other countries in the world. Many of them continue to buy assets through quantitative easing, and China is devaluing its currency and lowering interest rates. So that just makes it a bit harder for the Fed to get those interest rates back to normal.

When you say “move slowly,” you mean in terms of the number of rate increases?

The number and the magnitude. It’s going to be very, very gradual. The Fed’s used the word “crawl” to describe interest-rate normalization. It’s going to be a very slow crawl at that. So I do think they’re going to try to start the process this year. I still think September is a possibility as the first rate hike, though a December rate hike is most likely now given the recent global stock market volatility. But even if the move comes in September, the Fed is probably not going to do anything more than one hike this year. I think it might be well into 2016 before we see the next move from the Fed. So it’s going to be very, very gradual.

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