Should We Worry About Higher Interest Rates?

IMF Blog, July 29, 2014

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Global interest rates will eventually move higher; timing, speed, and magnitude are uncertain.
After a long period of very low interest rates following the global financial crisis, some central banks (mainly, the U.S. Federal Reserve and the Bank of England) are planning to “normalize”—that is, to gradually tighten their easy monetary policies as their economies improve.
When U.S. and U.K. benchmark interest rates go up, interest rates tend to go up elsewhere, too.
The 2014 IMF Spillover Report prepared by IMF staff examines what to watch out for and who to watch out for as interest rates begin to normalize.

Real shocks (higher interest rates and exit from monetary stimulus led by stronger growth prospects, e.g., in the U.S. and U.K.) produce good spillovers:
- Interest rates tend to rise elsewhere.
- Rates are lifted by a rising tide of economic activity at home and abroad.
- Trade and capital flows tend to strengthen.
Money shocks (interest rates moving up faster than suggested by the real economy) produce negative spillovers:
- Interest rates elsewhere tend to go up more sharply as liquidity conditions tighten in major financial centers.
- Capital tends to flow out, especially from vulnerable emerging economies.
- Foreign activity is dampened.

The report’s analysis attributes the main drivers of higher U.S. long-term yields since the taper episode to distinct components (including a monetary shock component).
Around the May 2013 taper episode and “over a year ago” since that turning point, mere talk by the U.S. Fed of tapering its purchases acted as a monetary shock or surprise to markets (blue area referenced in the report’s chart).
Consequences observed:
- Interest rates moved higher quickly.
- Market turbulence ensued.
- Negative spillovers were felt worldwide.
Central banks faced difficult trade-offs: if market expectations and risk-taking become too one-sided, course correction via higher rates may be needed even if growth is not stronger.
Given an unconventional starting point—low interest rates and large balance sheets—major central banks face complex challenges when normalizing smoothly.
Recent market volatility, spreads falling again to low levels, and asset prices moving up (some at all-time highs) are developments to watch.

Spillovers from higher interest rates depend on receiving countries’ local factors and fundamentals.
During the May 2013 taper episode, effects differentiated across emerging economies depending on fundamentals and policies.
Economies hit harder included those with:
- Higher external deficits or lower reserves.
- Higher inflation or weaker growth.
In those cases, interest rates rose or currencies fell by more.
Risks can interact: markets may reassess economies with weaker fundamentals in the context of rising interest rates and tighter financial conditions.
More vulnerable economies along these lines are the ones to watch going forward.

Should we worry about higher interest rates?
- Not if stronger growth is the reason; stronger growth is preferable to the alternative of lower interest rates and lower growth.
- The key challenge is managing the normalization process smoothly—transitioning along a path to higher growth and interest rates without destabilizing financial conditions.
- Given recent market trends, further bumps along the road are possible. Stay tuned.

Hamid Faruqee, July 29, 2014.