Thursday , 28 March 2024

Will Higher Interest Rates Result From Additional Tapering?

After a long period of very low interest rates following the global financial crisis theInterest-Rates central banks of the U.S. and U.K. are planning to gradually tighten their easy monetary policies as their economies improve. When their benchmark interest rates go up, interest rates elsewhere will go up to so should we worry if and when global financial conditions tighten?

The above introductory comments are edited excerpts from an article* by Hamid Faruqee (blog-imfdirect.imf.org) entitled Should We Worry About Higher Interest Rate? 

The following article is presented courtesy of Lorimer Wilson, editor of www.munKNEE.com (Your Key to Making Money!)and www.FinancialArticleSummariesToday.com (A site for sore eyes and inquisitive minds) and has been edited, abridged and/or reformatted (some sub-titles and bold/italics emphases) for the sake of clarity and brevity to ensure a fast and easy read. This paragraph must be included in any article re-posting to avoid copyright infringement.

Faruqee goes on to say in further edited excerpts:

The 2014 IMF Spillover Report…looks into this important issue—what to watch out for and who to watch out for as interest rates begin to normalize – and the answer depends on two sets of factors:

  1. what is going on in the originating source countries in terms of the underlying drivers behind higher yields—for example, whether or not stronger growth, say in the U.S. and U.K., is the main force behind higher interest rates and
  2. what is going on in the receiving countries—that is, how vulnerable they might be to higher borrowing costs.

Both these factors matter for spillovers as highlighted in the report.

Factors that drive yields highergood and bad spillovers

Good spillovers are produced by higher interest rates and exit from monetary stimulus…when led by stronger growth prospects (real shocks):

  • Interest rates tend to rise elsewhere, lifted by a rising tide of economic activity at home and abroad…[and]
  • trade and capital flows tend to strengthen.

Spillovers then tend to be negative when interest rates move up faster than what is suggested by the real economy (money shocks):

  • Interest rates elsewhere tend to go up more sharply as liquidity conditions tighten in major financial centers.
  • Capital tends to flow out, especially from vulnerable emerging economies.
  • Foreign activity is dampened.

Based on the report’s analysis, the chart below shows what have been the main drivers of higher U.S. long-term yields since the taper episode over a year ago.

Spillover Report

Notice what happened last summer.

  • Against a backdrop of low market volatility, low spreads, and high asset prices, mere talk by the U.S. Fed of tapering its purchases came as a monetary shock or surprise to markets (blue area)…[and] interest rates moved higher quickly.
    • Market turbulence ensued.
    • Negative spillovers were felt worldwide.

The problem is that the central bank may have had little choice: if it felt market expectations and risk-taking had become too one-sided, some course correction may have been needed.

Whether fully intended or not, Fed communications during the episode have clear lessons going forward.

  • Given an unconventional starting point—low interest rates and large balance sheets—major central banks face complex challenges when it comes to normalizing smoothly.
  • If markets get well ahead of themselves, financial stability concerns may require higher interest rates even if growth is not stronger. With recent market volatility and spreads falling again to low levels and asset prices moving up (some at all-time highs), this is something to watch out for.

What else matters for spillovers?

  • Spillovers from higher interest rates depend on local factors too.
    • During the May 2013 taper episode, for example, spillover effects were not all the same. Instead, effects differentiated across emerging economies depending on their fundamentals and policies.
      • Notably, those with higher external deficits or lower reserves, higher inflation or weaker growth were harder hit. Their interest rates rose or currencies fell…more.
  • Moreover, risks can interact.
    • Markets may reassess those economies with weaker fundamentals in the context of rising interest rates and tighter financial conditions.
      • Thus, more vulnerable economies along these lines are the ones to watch out for going ahead.

Bottom line

Should we worry about higher interest rates given the above? No, not if stronger growth is the reason… but the road ahead is a tricky one. Much will depend on how well the normalization process [i.e. tapering] can be managed. That is, how smoothly we can transition along a path to higher growth and interest rates.

Editor’s Note: The author’s views and conclusions in the above article are unaltered and no personal comments have been included to maintain the integrity of the original post. Furthermore, the views, conclusions and any recommendations offered in this article are not to be construed as an endorsement of such by the editor.

*http://blog-imfdirect.imf.org/2014/07/29/should-we-worry-about-higher-interest-rates/

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