The US Federal Reserve's decision not to raise interest rates was a political one, and not driven by economics. The long-term consequences of prolonging this 'managed depression' will not be pretty...

Last week’s decision by the US Federal Reserve not to raise interest rates was both a critical one and a poor one that will have consequences further down the line.

The ultra-low-interest-rate environment of the past six years should be seen as an exceptional response to exceptional circumstances. Quantitative easing was not a road anyone wanted to go down but in the face of economic meltdown it was the best route available. It was part of the reason we had what some economists have called “a managed depression” as opposed to an outright one.

But this is not territory anyone would wish to linger in. The task of central bankers should be to take the first available opportunity to get monetary policy back onto something of a regular footing.

With growth now consistently steady in the both the US and the UK and unemployment rates well down, both the Fed and the Bank of England should seize this moment to gradually re-establish some kind of normality. By delaying they expose us all to three big risks.

The first is that they overshoot in the low rate direction and then have to compensate by hiking rates rather than gradually raising them. While the greater risk at present seems to be deflation rather than inflation, this is due to one-off external factors such as commodity price falls whereas the big inflation driver – wage increases in a tighter labour market – will endure a lot longer. Given there are huge lags in transmitting interest rate changes, it would be better to get on the front foot now rather than be running to catch up later.

The second risk is that a low-interest-rate environment comes to be seen as a permanent part of the landscape with all the distortions that brings in terms of asset prices. Healthy economies are ones where credit is priced moderately and sensible borrowing decisions are taken on that basis. While the period of low interest rates has allowed those who were overextended from the last crisis to deleverage, it has also allowed a new generation of players – many of them first-time home buyers – to believe that low interest rates are forever. This means that when they do go up, the crunch as borrowers adapt will be that much worse.

Finally, central banks risk doing to monetary policy what governments all round the world have already done to fiscal policy – making it political and therefore ineffective. Reducing interest rates and increasing government spending are easy decisions – they keep growth motoring and everyone is happy: consumers, businesses and governments.

But raising rates and cutting spending are essential if policy is to balance over the cycle. We already have a situation in fiscal policy where politics has taken over from economics and so-called Keynesians advocate deficits to offset slowdowns but are totally against surpluses in growth periods. If central banks cannot show they have the muster to raise rates and fear instead a political backlash, they merely compromise their independence.

Regrettably the Fed has taken us one step nearer this unhappy conclusion. The most telling part of the debacle is that emerging market leaders, whose economies would be hit hardest by a rate rise, have been advocating an increase. This is because they recognise that permanent low rates are untenable and that volatility will be less if markets adapt sooner rather than later. What a pity they were not listened to. 

Brian Caplen is the editor of The Banker.

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