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 set to be 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 this year 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 lead to 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 decline 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 were so significant that the rate increases had only a marginal effect.
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 boost innovation during times of economic struggle or rising interest rates.
How can higher interest rates limit innovation and economic growth, particularly in the context of borrowing for research and development?
Turn, limit innovation and economic growth.
The study further highlights that higher interest rates can discourage investment in research and development, as it becomes more costly to borrow for these purposes. This can have a detrimental effect on technological advancements and hinder the potential for future economic expansion.
The findings of this paper have significant implications for policymakers and central banks. It suggests that while raising interest rates may be necessary to combat inflationary pressures, the long-term consequences on economic output and growth potential should also be considered. A balance needs to be struck between addressing immediate inflation concerns and fostering an environment that encourages innovation and productivity.
The authors propose that increased government funding for innovation could help offset the negative impact of interest rate increases. By providing financial support for research and development, governments can stimulate innovation and counteract the potential slowdown in economic growth resulting from higher borrowing costs.
The debate on interest rates is currently ongoing within the Federal Reserve. While inflation is a critical concern, there is also a recognition of the importance of maintaining a conducive environment for long-term economic growth. Finding the right balance between the short-term need to combat inflation and the long-term goal of promoting innovation and productivity is a complex and challenging task.
This study serves as a reminder that monetary policy decisions should not solely focus on short-term objectives but also consider the broader, long-term implications for the economy. It calls for a comprehensive approach that takes into account both inflation control and the promotion of innovation to ensure sustainable economic growth in the years to come.
