Hiking interest rates aggressively, as the Federal Reserve has done over the past 14 months, not only fights inflation but also has long-term consequences for the economy’s output and growth potential. This is the conclusion of a paper presented at the Federal Reserve’s annual conference in Jackson Hole, Wyoming.
The study, conducted by economics and finance professors Yurean Ma and Kaspar Zimmerman from the University of Chicago, suggests that monetary policy can impact the productive capacity of the economy in the long term. It argues that a slower pace of innovation, resulting from higher interest rates, can have lasting effects on economic growth.
According to the authors, a percentage point increase in interest rates could reduce economic output by 1% up to nine years later. Given that the Fed has raised its key interest rate by 5.25 percentage points since March 2022, the study suggests that this campaign could lead to a 5% reduction in output in the coming years.
While inflation is easing and economic and job growth remain strong, Fed officials are currently debating whether to raise rates again or maintain them to avoid a possible recession.
The study does not conclude that the Fed should refrain from raising rates to contain inflation. Instead, it suggests that increased government funding for innovation could offset the negative effects of rate increases.
Traditionally, economists believed that interest rate changes did not affect the economy’s long-term potential. However, recent research challenges this view. Higher interest rates make borrowing more expensive, reducing consumer and business demand for products and services. This can make it less profitable for companies to develop new offerings and innovations that increase efficiency and drive growth.
Rising interest rates can also lead to less favorable financial conditions, making it more expensive to take out loans for new ventures. Investors may choose to put their money in safe bonds that offer higher interest rates instead of taking risks on new ventures.
The study finds that a percentage point increase in interest rates can result in a 1% to 3% reduction in research and development spending within one to three years. Venture capital investment falls by 25% in the same timeframe, and patents for new inventions decline by up to 9% within two to four years. This decrease in innovation leads to a 1% drop in output five years later.
The current rate-hiking cycle, with the Fed raising its benchmark rate by more than 5 percentage points since March 2022, could have more pronounced effects. Venture capital investment has already fallen by about 30% annually since the hikes began, impacting all major sectors. However, investment in generative AI has rebounded due to Microsoft’s $10 billion investment in OpenAI.
The dropoff in patents affects both public and private companies, large and small. Large public firms may be more affected by softer customer demand than unfavorable financial conditions due to their greater financial resources.
The study also notes that Fed rate hikes do not always discourage innovation. In the 1970s and 1980s, when computers took off, inflation and interest rates were high, but the technological developments outweighed the marginal effect of rate increases.
The authors do not suggest that the Fed should necessarily hold off on further rate increases or quickly cut rates. Instead, they propose that government programs could provide grants or subsidies to companies to support innovation during times of economic struggle or rising interest rates.
What are the potential consequences of the Federal Reserve’s aggressive rate hiking strategy on economic output and long-term growth?
Conomic output and long-term growth.
The study highlights the potential consequences of the Federal Reserve’s aggressive rate hiking strategy. It argues that higher interest rates can stifle innovation and slow down economic growth in the long run. The authors suggest that a 1% increase in interest rates can result in a 1% reduction in economic output up to nine years later. With the Fed increasing rates by 5.25 percentage points since 2022, the study suggests a possible 5% reduction in output in the future.
Despite easing inflation and strong economic and job growth, the Federal Reserve is currently debating whether to raise rates again or maintain them to avoid a recession. The study does not argue against rate hikes to control inflation but suggests that increased government funding for innovation could counteract the negative effects of higher rates.
Traditionally, economists believed that interest rate changes had no long-term impact on the economy’s potential. However, recent research challenges that belief. Higher interest rates increase borrowing costs, which can reduce consumer and business demand for products and services. This, in turn, can make it less profitable for companies to invest in developing new offerings and innovations that drive economic output and growth.
Overall, the study emphasizes the importance of considering the long-term effects of aggressive interest rate hikes on the economy, particularly in terms of innovation and growth potential. It suggests that policymakers should not overlook the potential negative consequences and explore other avenues, such as increased government funding for innovation, to mitigate the impact of rate increases.
This analysis is crucial for understanding the potential consequences of aggressive interest rate hikes on the overall economic growth in the long run.
I’m curious to learn how these aggressive interest rate hikes might also affect inflation rates and consumer spending patterns.