The Impact of the Raising of Interest Rates on the US Economy
June 04, 2004
In the United States, the considerable improvement in employment conditions and the increasing clarity of the Fed's positive stance on the raising of interest rate, the long-term interest rate has risen approximately 1.2% points, from a low of 3.68% in mid-March to 4.86% in mid-May. Most recently, it is possible that the level of the long-term bond market has already taken account of the 1% rise in the FF induced level of interest rates.
A survey of financial conditions in the household sector reveals that the debt ratio (ratio of debt to disposable income and to total assets), and the repayment burden ratio is at its highest level to date, but given (i) the high ratio of fixed-rate debt and (ii) the expanding trend of the economy in recent months, a high level of debt in itself may not necessarily translate into downward pressure on the household sector at a time when interest rates are rising.
What are the effects of a rise in interest rates on disposable income? In the household sector, where assets outweigh debt, a 1% rise in interest rates will boost nominal disposable income by 0.4%. However, a rise in interest rates causes the value of assets such as shares and housing to fall, and given the indirect impact that this will have on consumption, etc., real consumer spending will fall by 0.4%. Taking the household sector as a whole, including the fall in investment in housing (of 1.9%), a 1% rise in interest rates would depress real GDP by 0.4%.
In the corporate sector, a 1% rise in interest rates will lead, by two routes - (i) a 2.8% reduction in corporate profits due to the direct increase in the burden of interest payments and (ii) the indirect effects of a fall in asset values, the deceleration of consumer spending, etc., - to a 3.4% fall in capital investment, pushing real GDP down by 0.3%.
Taking the impact on the corporate and household sectors together, a 1% rise in interest rates is likely to reduce real GDP over the next year by 0.7%. As the US economy is currently in a cyclical recovery phase, the impact of a 1% rise will not be so great as to trigger a severe recession but is likely to prevent the pace of economic growth in the second half of 2004 from rising above the 4-5% range seen in the first half of the year, and may cause it to slow down to the 3-4% range.
Moreover, if the fall in the value of assets such as shares and housing triggered by a rise in interest rates is greater than expected, there is a risk that household balance sheets will deteriorate, pushing the real economy down still further.
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