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Ben Bernanke: Interest Rates To Remain Low
Aspire, Thought Leaders | 27 April 2015
By: Lim Si Jie
Articles (169) Profile

Central banks around the world do not seem to be raising interest rates, both short-term and long-term. Rates have been exceptionally low for quite some time now and many are asking if the rates will maintain or go even lower. Dr Ben Bernanke, ex-Chairman of the Federal Reserve discussed some notable implications of low interest rates on the economy.

Real Interest Rates, Not Monetary Policy

The Fed’s policies are the primary determinant of inflation and inflation expectations over the longer term, and inflation trends affect interest rates. For example, if the Fed forecasts that inflation is on a rise, it will increase interest rates to help reduce the demand for loans. The result is that consumers have less money to spend, causing the economy and inflation rate to slow down.

Although investors might be more interested in the short term interest rates of The Fed, it is vital to note that what matters most for the economy is the real (inflation-adjusted) interest rate. Dr Bernanke points out that the Fed’s ability to “affect real rates of return, especially longer-term real rates, is limited.” Contrary to common belief, real interest rates are determined by a wide range of economic factors, including prospects for economic growth but not by the Fed.

Finding The Ideal Interest Rate Level

In order for Fed to guide the United States to full employment of capital and labour resources, it has to influence market interest rates towards levels consistent with Fed’s best estimate of the equilibrium rate, which is not directly observable.

According to Dr Bernanke, the economy will slow down if the Fed keeps market rates too high, relative to the true equilibrium interest rate. Similarly, if the Fed decides to push the rates lower than levels of equilibrium, the economy would eventually overheat, leading to inflation. Either of these situations are undesirable and unsustainable.

Healthy Economic Recovery

The bottom line is that the state of the economy, not the Fed, ultimately determines the real rate of return attainable by savers and investors. The Fed influences market rates but not in an unconstrained way; if it seeks a healthy economy, then the Fed must try to push market rates towards levels consistent with the underlying equilibrium rate.

Premature Interest Rate Hikes Will Hurt US

In the weak (but recovering) economy of the past few years, all indications point towards an equilibrium real interest rate that is exceptionally low, probably even negative. A premature increase in interest rates engineered by the Fed would likely lead to an economic slowdown instead. The slowing economy in turn would force the Fed to capitulate and reduce market interest rates again.

In recent years, several major central banks have prematurely raised interest rates, only to be forced by a worsening economy to backpedal and retract the increases. In 2011, China raised its interest rates to curb rising inflation. However, deflationary risks and the property market slowdown is leaving Bank of China with no choice but to cut back its interest rates in end 2014. Bank of China then went on to cut its interest rates for the second time in February this year.

Interest Rates To Remain Low

Ultimately, the best way to improve the returns attainable by savers was to do what the Fed actually did: keep rates low (closer to the low equilibrium rate), so that the economy could recover and reach the point of producing healthier investment returns more quickly.

With the latest non-farm payroll showing slowdown in employment, a rate hike in June is becoming more and more unlikely. Given the cautious nature of the current FOMC members, the Fed is unlikely to risk raising interest rates prematurely. More data supporting a strong economic recovery in the US economy will be required before the Fed decides on its next move.

The change in market sentiments on the timing of interest rate hikes has slowed down the uptrend of major indexes. After recent pullbacks, it might be a good time to go long on these major market indexes again before the market continues to go higher on expectations of low interest rates till late 2015.

Si Jie is no stranger to investing having started his journey at a young age. He is heavily influenced by acclaimed investors such as Benjamin Graham, Peter Lynch, and John Rothchild.

Please click here for more information about this author.

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