20 October 2016
A rate hike by the Federal Reserve will signal confidence in the US economy's prospects. Photo: Bloomberg
A rate hike by the Federal Reserve will signal confidence in the US economy's prospects. Photo: Bloomberg

Why a Fed move will help stimulate demand

There have been some arguments that the US Federal Reserve should hold off on its rate hike as the supporting factors for wage growth are still weak in the country, and as the global economy is also plagued by many uncertainties.

We think the argument is flawed.

People are mistaken if they think that a lift in short-term interest rate from near zero will impact the overall demand. In reality, interest rate is not in linear relationship with the overall demand.

In the initial leg of the cycle, upward adjustment of the rate will actually boost the economy, rather than suppress demand.

Market participants have worried that interest rate hikes will create a destructive impact with the price effect, and that the fallout in terms of the wealth effect, expectation effect and confidence effect will have negative impact on demand.

In fact, before these “effects” can begin to drag down the economy, a shift away from the super-loose monetary policy can actually stimulate economic growth.

If the situation goes well, the economy can achieve a soft landing with higher output and interest rate levels. The US should have actually raised its key rate in September.

Below are six “effects” which show how short-term interest rate influences the economy:

1) Income effect: Higher interest rate will boost depositors’ interest income and borrowers’ interest expenditure. For families, the assets that bring interest income are usually far more than the debts with floating rate. Thus an increase in short-term interest rate will have net positive influence on household incomes, which will support demand growth.

2) Price effect: Higher borrowing costs may prompt some companies to give up investment projects, while fewer families may apply for mortgage loans. This will curb home price growth.

3) Wealth effect: Higher interest rate will lead to higher discount rate when evaluating assets. So the asset value will shrink, according to the popular view. However, past experience has shown us that a rise in interest rate from a very low level could fuel a stock market rally and boost the value of financial assets.

4) Exchange rate effect: Foreign exchange traders will tend to invest in currencies with higher overnight rate, boosting demand for the greenback and pushing up its value. As currencies of other nations weaken, their export sectors will benefit.

5) Expectation effect: When the central bank begins its rate liftoff and give hints of further increases, families and companies may try to borrow early before rates move even higher. That will help boost consumption and investment.

6) Confidence effect: Moving away from low interest rates is is seen as a sign of confidence in the economy’s prospects. Improved economic confidence will spur corporate as well as personal spending.

At present, the most important thing is demand. We think the positive influence from income, wealth, confidence and expectation effects will outweigh the negative impact from the price effect. Hence, the initial increase in interest rate will be positive to the economy.

Adapted from an article that appeared in the Hong Kong Economic Journal on Nov. 16.

Translation by Myssie You

[Chinese version中文版]

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Chief Asia Market Strategist at JP Morgan Funds

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