Vigorously raising interest rates, as the Fed has done over the past 14 months, does not fight inflation by simply curbing economic growth in the short term.
This strategy also limits the economy’s output and long-term growth potential by discouraging innovation, according to a paper scheduled to be presented Friday at the Federal Reserve Bank’s annual conference in Jackson Hole, Wyoming.
“Our findings suggest that monetary policy may affect the productive capacity of an economy in the long term,” says the study, led by Urian Ma and Kaspar Zimmermann, professors of economics and finance at the University of Chicago. “The slowing pace of innovation could have lasting effects.”
In general, a percentage point increase in interest rates could reduce economic output by 1% for up to nine years after that, the authors say. Since the Fed has raised the key interest rate by 5.25 percentage points since March 2022, this suggests that the campaign could lead to a 5% decline in output in the coming years.
With inflation subdued but still high and economic growth and jobs remaining strong, Fed officials are debating whether to raise interest rates again this year or keep them flat to avoid a possible recession.
However, the study does not conclude that the Fed should necessarily refrain from raising interest rates if needed to contain inflation. Instead, it suggests that increased government funding for innovation can offset increases in the rate.
What happens to economic growth in the long run when interest rates rise?
The paper says that economists traditionally believe that the long-term potential of the economy is not affected by raising interest rates to curb inflation or lowering them to stimulate weak growth. But this view has been challenged by a growing body of research.
And by making borrowing more expensive, higher interest rates can reduce consumer and business demand for products and services. This, the paper says, can make developing new offerings and innovations less profitable for companies, increasing efficiency and spurring faster growth.
A sharp rise in interest rates could also lead to less favorable financial conditions. This means that it becomes more expensive to obtain a loan to launch a new product or business, the stock market has declined and investors are more likely to put their money into safe bonds that now pay a higher interest rate than risk new bonds. venture.
The study says that raising the interest rate by one percentage point can reduce spending on research and development by 1% to 3% within one to three years. In the same time frame, venture capital investment fell by 25%. The study says that patents for new inventions decrease by up to 9% in two to four years.
An index of total innovation based on the economic value of patents fell 9% in that period, leading to a 1% drop in output five years later.
How far has the Fed raised interest rates?
The effects could be even more pronounced in the current rate-raising cycle since the Fed raised its benchmark interest rate by more than 5 percentage points from near zero in an effort to tame the historic high inflation. Since the increases began in March 2022, the study says, venture capital investment has fallen from its peak in 2021 by about 30% annually. The downturn has affected all major sectors, not just those “sometimes seen as speculative bubbles”, such as cryptocurrencies.
Investment in AI (artificial intelligence) rebounded this year, the paper says, but this was mostly buoyed by Microsoft’s $10 billion investment in OpenAI.
Meanwhile, the study says, the decline in patents affects public and private companies as well as companies large and small. But since large public companies have greater financial resources, their decline in innovation is more likely to be driven by weak customer demand than by unfavorable financial conditions.
What happened to interest rates in the late 1970s and early 1980s?
The study says that raising Fed interest rates does not always discourage innovation. The study says that when computers took off in the 1970s and 1980s, inflation and interest rates were high, but technological developments were so dramatic that higher prices had only a marginal effect.
The authors do not necessarily urge the Fed to delay further rate hikes or move quickly to cut rates.
The study says: “We do not believe that our findings necessarily mean that monetary policy should be more pessimistic,” which means that it is directed more towards lowering interest rates than raising them.
Alternatively, the authors say, government programs could provide grants or subsidies to companies to support innovation if the economy is struggling or interest rates are rising.
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