Today at the FOMC meeting, the Federal Reserve released statements that were more dovish than analysts had expected regarding the short term interest rate. On February 7, I posted a blog highlighting my analysis and contrarian view that the Fed would stay patient in raising the short term interest rate despite popular beliefs it would come sooner rather than later. Now I am not saying that I have achieved victory in my prediction, but it is one step closer in the right direction. My prediction came at a point after a point when the most recent U.S. economic data was strong. The Fed minutes suggested that U.S. data was weak according to a report by the Wall Street Journal: “The action followed a round of soft economic data and signs from the minutes of January’s Fed meeting that the central bank is grappling with how to lift U.S. rates for the first time since 2006.” That is a long time period since the Fed last raised interest rates, and there are many new factors in play considering we have experienced the Great Recession and experimented with new forms of monetary policy.
Raising interest rates has many negative implications. Domestically, it makes it harder to borrow in the sense that debt is relatively more expensive. Say you have a floating rate mortgage and today your payment is 4%, your payment might go up substantially if the mortgage rate moves to 6%. Also, there are more first time home buyers that may not be able to afford a house if their mortgage payment is higher due to the rise in interest rates. These are only a few sheltered examples related to one industry that would be negatively affected by a rise in interest rates. An interest rate increase also has some positive effects, too. Another Wall Street Journal article highlighted the market effects due to interest rates being held lower. “The yield on the two-year U.S. Treasury note fell by about 0.07 percentage point Wednesday to 0.605%, the biggest one-day decline since August 2011. The yield, which falls as prices rise, is among the most sensitive to changes in the Fed’s interest-rate outlook.” Essentially, investors earn less return on their money when interest rates are low.
Another negative of raising the interest rate arises in international finance. When the Fed raises the interest rate, that will lead to a decrease in net capital outflows, and an increase in the U.S. dollar exchange rate. The increased exchange rate can be viewed as a positive since it signals a strong economy, but will ultimately hurt net exports. This dilemma can also be viewed from the net capital outflows decreasing according to the equation NCO=NX. Essentially, net capital outflows are equal to net exports and boost a country’s GDP. So when net capital outflows fall due to an increase in the interest rate, the U.S. GDP is also expected to be weakened.