Normality? Not yet

In economics there are different definitions of interest rate, which could create a bit of confusion, especially by their different usages. A rough definition of interest rate is the cost of borrowing money. In the Central Bank world, the interest rate is the one at which the Central Bank lends money to commercial banks, and through this rate it tends to influence all the other ones (mortgages, savings, bonds rates, etc.). Despite some technicalities, central bankers use this instrument to reach their goals of monetary policy.

A clear example is the Fed in these days. After a turbulent end of summer, with a dramatic crash of the Asian financial market, the world faced one of the most awaited events: the forthcoming Fed choice upon interest rate.

The importance of this event is obvious: since December 2008 the rate is fixed at 0.25%. Raising the rate would be extremely significant because it marks the end of the accommodating policy. And, of course, this implies that the world is going to come back to normality, but unfortunately this is not what is going to happen.

American economy is growing around 4% per year, unemployment is going down at 5.1%, inflation is close to zero and so are its expectations. Such a scenario looks overall positive from a central bank point of view, but this is due to not-normal interest rate level. Or differently, the global situation is not normal yet: the crisis has not been overcome yet.

Usually, if a central banker is worried about higher inflation, then he will decide to raise the base rate in order to push for some effects, as to increase the cost of borrowing, increase incentive to save, increase the value of his currency, increase the weight of government debt and discourage investments. Therefore, final effects will be slower economic growth, higher unemployment and improvement in the current account. In this way, he tries to stabilize the economic cycle.

However, several reasons induce Fed to keep interest rate fixed, at least in September. From a national point of view, the inflation rate is too close to zero that Fed is concerned by a downward trend, despite the actual situation. While from a global point of view, the economy is not recovery yet, China’s slowdown, low prime-material prices, and many other factors generate an involuntary raise of the financial conditions in the US. In addition, rising interest rates will produce an outflow of capital from emerging countries, which could undermine financial markets.

Hence, Fed prefers to postpone its monetary tightening, but Yellen confirms again the willingness to increase it within the next months; some analysts even suggest within the end of 2015.

The next appointment will be on October 30th or December 18th. Predict the future choice of the Central Bank is always hazardous, but now some key information has been released for the forthcoming choice.


Stefano Olivari

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