In a new report by JP Morgan Asset Management titled Avoiding the stagnation equilibrium, it was argued that the first few rate hikes by the US Federal Reserve will boost aggregate demand.
“The real-world relationship between interest rates and aggregate demand is non-linear and an examination of the transmission mechanisms suggest that the first few rate hikes, far from depressing aggregate demand, would actually boost it,” the report said.
“The reason [the Fed] should have raised rates in September and the reason, failing that, that it should do so this month isn’t that the economy can handle the pain but rather that it could do with the help.”
The report found that raising short-term interest rates from low levels will likely increase aggregate demand as positive income, wealth, expectations and confidence effects outweigh negative price effects and ambiguous exchange rate effects.
“Monetary tightening from super-easy levels can actually accelerate the economy beyond its potential growth rate before slowing it, ideally to a soft landing at a higher level of output and interest rates,” the report said.
The report pointed out that in terms of expectations, when a central bank begins to raise rates businesses and households may attempt to borrow ahead of further rate hikes – boosting consumption and investment.
Moreover, when a central bank raises rates, it can improve investment confidence.
The report also argued that over time, a zero interest rate policy may inflate certain asset classes and lead to growth in debt.
The report said that there is a risk that the Fed will be stuck in a “stagnation equilibrium”. This means that a zero interest rate policy continues to reduce demand in the economy, prompting the Fed to keep rates on hold and fuel the problem.
“However, the most urgent point is simply that, right now, the economy could do with a little more demand.
"We believe that the positive impacts of income, wealth, confidence and expectations effects are only slightly offset by negative price effects and thus the first few rate increases would actually boost demand,” the report said.
