Aggressive rate hikes, such as the Federal Reserve has been conducting over the past 14 months, not only fight inflation by dampening economic growth in the short term.
The strategy also constrains the economy’s long-term output and growth potential by impeding innovation, according to a paper due to be presented Friday at the Fed’s annual conference in Jackson Hole, Wyoming.
“Our results suggest that monetary policy could affect the economy’s productive capacity over the longer term,” say the study by Yurean Ma and Kaspar Zimmerman, professors of economics and finance at the University of Chicago. “A slower pace of innovation can then have lasting effects.”
Overall, a 1 percentage point increase in interest rates could reduce economic output by 1% up to nine years later, the authors say. With the Fed raising interest rates by 5.25 percentage points since March 2022, this suggests the campaign could lead to a 5% fall in output in the coming years.
With inflation easing but still high and economic and job growth remaining robust, Fed officials are debating whether to raise rates again this year or hold them steady to avoid a potential recession.
However, the study does not conclude that the Fed should absolutely refrain from raising interest rates when it is necessary to contain inflation. Rather, it suggests that increased government funding of innovation could offset wage increases.
What happens to long-term economic growth when interest rates rise?
Economists have traditionally assumed that raising interest rates to curb inflation or lowering them to spur sluggish growth will not hurt the economy’s long-term potential, the paper said. However, this view has been challenged by a growing body of research.
By making borrowing more expensive, higher interest rates can reduce consumer and business demand for products and services. This could make it less profitable for companies to develop new offerings and innovate that increase efficiencies and lead to faster growth, the paper said.
Sharply rising interest rates can also lead to less favorable financial conditions. This means that it becomes more expensive to borrow to launch a new product or company, the stock market is in the red and investors are more likely to invest their money in safe bonds that are now paying a higher interest rate than take the risk of one dare to enter into a new product.
A one percentage point hike in interest rates could reduce research and development spending by 1 to 3 percent in one to three years, the study says. Over the same period, venture capital investment falls by 25%. And patents for new inventions decline by up to 9% in two to four years, the study says.
Also, an aggregate innovation index based on the economic value of patents falls by 9% over this period, leading to a 1% drop in production five years later.
How much has the Fed hiked interest rates?
The impact could be more pronounced in the current rate-hike cycle, as the Fed has raised interest rates by more than 5 percentage points from near zero in a bid to stem a historic rise in inflation. Since increases began in March 2022, venture capital investment has fallen by about 30% annually from its peak in 2021, the study said. The pullback has affected all major sectors, not just those “sometimes perceived as bubbles,” such as cryptocurrencies.
Investments in generative AI (artificial intelligence) have picked up again this year, but that’s mostly due to Microsoft’s $10 billion investment in OpenAI, the paper said.
Meanwhile, the decline in patents is affecting both public and private, large and small companies, the study said. However, because large public companies have more financial resources, their decline in innovation is more likely to be due to weaker customer demand than unfavorable financial conditions.
What happened to interest rates in the late 1970s and early 1980s?
Fed rate hikes don’t always stifle innovation, the study says. Inflation and interest rates were high when computers emerged in the 1970s and 1980s, but technological developments were so dramatic that rate hikes had only a marginal impact, the study says.
And the authors aren’t necessarily urging the Fed to withhold further rate hikes or cut rates quickly.
“We don’t think our results necessarily suggest that monetary policy should be more dovish,” the study says, meaning that it should be more focused on rate cuts than rate hikes.
Instead, the authors say, government programs could give grants or subsidies to companies to encourage innovation when the economy struggles or interest rates rise.
Comments are closed.