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Markus Demary IW News 2. February 2017

Fed’s interest rate decision: Conflict postponed

The US Federal Reserve has not raised its key interest rates despite good economic data. The new US government is likely to be satisfied with this decision, because low interest rates help to fund its planned infrastructure projects. The political pressure on the Fed is therefore likely to increase.

The low-interest rate policy of the recent years has contributed to a higher indebtedness in many countries. In the United States, the debt ratio rose from 63 percent of gross domestic product in 2007 to 105 percent in 2016. A similar picture emerges within the euro area, where government debt rose from 65 percent to 93 percent during the same period. If interest rates rise, many high-indebted countries would get into difficulties: because of the high debt level, their financing costs would rise more sharply than in the past. For the US, this means that an interest rate hike by 0.25 percentage points would raise government interest payments by 12 percent, in the past, this would have been only 5 percent.

In addition to the already high debt level, the new US government under Donald Trump is planning major infrastructure investments, from transport systems to water supply. Trump plans investments in the amount of one trillion dollars over the next ten years. At the current interest rate on 10-year government bonds of 2.1 percent, interest payments on these investments would amount to 210 billion dollars over the next ten years. However, if the Fed realizes their previously announced rate hikes this year, policy interest rates will rise by 0.75 percentage points. Then, Trump’s plan could become much more expensive by an estimated 25 percent or 52 billion dollars. The political pressure on the Federal Reserve to keep interest rates low might therefore increase.

Based on economic data, however, the economic development in the US requires higher interest rates: the unemployment rate has fallen from 10 percent in 2009 to 4.7 percent, price-adjusted economic growth is close to 2 percent, and consumer prices are currently up by 1.6 percent compared to last year. The trend towards higher inflation rates will continue, especially as the rise in crude oil prices has a time-lagging effect on inflation. Under these circumstances, the Fed's continued low-interest policy would turn to pure state funding.

It is questionable whether and how Trump will intervene in monetary policy. In addition to his Twitter announcements, he could soon appoint a new presidency, since Fed Chairman Janet Yellen's term ends at the beginning of 2018. He is not completely free in his choice, because he can only appoint one of the six other current Fed governors. An open conflict between the government and the central bank would seriously damage confidence into a stability-oriented monetary policy.

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