Predicting Where the Rise in US Interest Rates Will End
- Towards a Temporary Lull With a +0.50% Increase -
June 24, 2005
This report considers the "neutral" level of policy interest rates in the United States and attempts to predict the point at which the FRB's interest rate hikes, which began in June last year, will settle.
An examination of the relationship between real FF rate and real GDP in the United States reveals that the level of interest rates that is neutral towards the economy varies considerably from one phase of the economic cycle to the next. Moreover, FRB Chairman Alan Greenspan takes a different approach to monetary policy-making from that of the Taylor Rule, which is based on a "neutral" interest rate level.
Meanwhile, since the second half of the 1980s, the link between the real FF interest rate and the GDP gap has become noticeably stronger. In phases where a GDP gap persists, the economy is steered by using a relaxed monetary policy to encourage a rate of economic growth higher than the latent growth rate and reducing the degree of relaxation as the GDP gap narrows. Incidentally, a review of the relationship between the two over the period 1988-2000 reveals that, when the GDP gap is closed, the real FF rate tends to be around +3%.
On the assumption that there continues to be a link between the GDP gap and the real FF rate, how much scope is there for further interest rate increases? The raising of interest rates is likely to continue until a neutral real FF rate is reached (around +3%, or 4.5-5.0% for the nominal FF rate). However, a GDP gap of -1.3% persisted during the January-March quarter of 2005 and, in the short term, it is likely that any further interest rate increases will only raise the real FF rate to a level that balances this GDP gap (around +2%), in other words, any further increases will be no greater than 0.50-0.75%. Assuming that, due to inventory adjustments, etc., economic growth remains at much the same level as the latent growth rate for the foreseeable future, it is likely that interest rate increases will thereafter be suspended for a time and that the FRB's stance will change to one of fine-tuning, with an eye on the economic trend. These observations are confirmed by the relationship between the unemployment rate and the capacity utilization rate, which serves as a proxy variable for the GDP gap.
However, at a time when the FRB has lost control over long-term interest rates, there is room for doubt as to whether or not raising lending rates will have the desired effect. In term of the investment-saving balance in the US corporate sector, there is little incentive to raise the real FF rate significantly above its present level and the increasing vitality of consumption and investment in the household sector due to the fall in long-term interest rates is narrowing the GDP gap. Under such conditions, any hasty move to raise interest rates would not only risk prolonging the cautious stance on investment in the corporate sector but could even lead to the collapse of the housing bubble through a substantial rise in long-term rates, and it is likely that the FRB will have to maintain its cautious stance on the raising of interest rates.
For more information on the content of this report, please contact: Takeshi Makita the Japan Research Institute, Limited.