Effects of past interest rate increases offer guide to future risks

The US Fed's task this time is even more complicated because other central banks are leaning in the opposite direction

Fire or ice?
When expansions end and the economy tips into recession, one or the other is usually to blame.

In the past, the culprit has frequently been fire - an overheating economy and rising inflation - that prompted the central bank to push up interest rates until they ultimately choked off growth. Ice is more unusual, at least in the United States, but often more painful, as excess capacity, weak demand and falling prices foster a deflationary slump that can prove difficult to escape.

As the Federal Reserve embarks on a new chapter in monetary policy, having raised rates on December 16 for the first time in nearly a decade, policy makers are acutely aware of the risks posed by either possibility.

"Raising rates the first time may have been the easy part; now comes the challenging part," said Mike Ryan, chief investment strategist for UBS Wealth Management Americas.

Fed officials do not have to look far for real-world examples of what can go wrong.

European central bankers raised rates twice in 2011, killing off a nascent recovery and plunging the euro zone into a double-dip recession that it is still struggling to overcome.

But being too slow to tighten the reins of monetary policy can prove perilous, too.

A series of steady quarter-point rate increases by the Fed between 2004 and 2006 seemed prudent at the time, but in hindsight the central bank has been blamed for moving too slowly, failing to head off the economic catastrophe that followed the implosion of the housing bubble in 2007.

The biggest problem is that higher interest rates do not bite in predictable ways. Not only do they take time to percolate through the real economy, but there is also a difficult-to-foresee threshold at which the impact can suddenly shift from mild to severe.

"I'm sure there is a tipping point," Ryan said. "It's just hard to know in advance precisely where that is."

At least for now, though, few analysts expect the Fed's initial moves to bring the nation's six-and-a-half-year-old expansion to an abrupt end.

"The rate hike this month and those next year may not really be felt until 2017," said Michael Hanson, senior United States economist at Bank of America Merrill Lynch. "Evidence from past cycles suggests it could take a year, rather than the next quarter or two."

The Fed's task this time is even more complicated because other central banks are leaning in the opposite direction.

With growth in Europe still sputtering, the European Central Bank has belatedly turned to the tools embraced by the Fed several years ago, buying up securities and pumping money into the financial system. But even with some interest rates there in negative territory, Mario Draghi, president of the ECB, is under pressure to loosen monetary policy further.

In Asia, the People's Bank of China is also in easing mode, as officials try to cushion what looks like an increasingly hard landing for the economy there, the world's second-largest. Similarly, Japan's central bank is keeping interest rates at rock-bottom levels to encourage growth.

The combination of lower rates abroad and rising ones at home is making the United States dollar surge against other currencies. While that might be good for American tourists heading overseas, it hurts American manufacturers seeking export markets and makes imported goods more competitive, undermining the country's trade balance.

For now, most economists say the danger of too little inflation outweighs the risk of too much: Ice, in effect, may be more of a worry than fire.

"The risk is skewed toward moving too fast," said Michael Gapen, chief United States economist at Barclays. "That's especially true as the strong dollar and lower-priced imports keep inflationary pressures at bay in the United States."

Although Gapen, like most seers on Wall Street, is generally upbeat about the economy's prospects next year, some of his colleagues elsewhere are less sanguine. David Levy, a longtime private economist, is warning clients that the Fed may be forced to reverse course as weakness in China and emerging markets redounds to the United States.

The Fed's rate increase on Wednesday, Levy cautioned, "may well mark a high point in economic expectations for 2016."

In its statement Wednesday about the decision to raise rates, the Fed itself noted there had been a "shortfall" in terms of actual inflation's not measuring up to the central bank's 2 per cent goal, which it considers helpful in supporting a more robust economy.

©2015 The New York Times News Service