The First Step Adjusting Interest

In the fast reality of the financial markets, it already seems an eternity ago. But yesterday, the year 1994 briefly haunted the dealing rooms. On February 4 of that year, the American Federal Reserve Board (Fed), the system of central banks in the U.S., raised the interest rate for the first time since the recession of those days. The interest stood at what was then considered an unusually low 3 percent. It was urgently needed in 1994: The economic recovery was in its third year and it was only a matter of time for the normalization of interest rates. Still, the markets responded turbulently to that first step in adjusting interest rates and the increases that followed thereafter. State bonds dropped significantly in value that year and the effective interest on state debt increased worldwide in terms of percentage points. The interest increase came, as they say, still unexpected.

A broadening of the monetary policy with decreasing interest seldom gives rise to acute problems, even though the extremely low American interest rates of the past ten years were determined to be a cause of the burst of the credit bubble. In contrast, the scaling down of such an interest policy needs to be done with great caution. The decision yesterday by the American Fed to increase the so-called discount rate from 0.5 percent to 0.75 percent is viewed on the financial markets as the first step toward normalization of the monetary policy.

That policy is very lenient. The main interest rate, the so-called federal fund rate, lies between 0 percent and 0.25 percent. There is still a tolerant policy regarding securities that can be loaned by banks in exchange for cash. The discount rate is, in the American system, an interest against which banks can turn to the central bank if they cannot get money anywhere else. Therefore, as a punishment, this interest is higher than the most important rate. Yesterday’s increase is largely symbolic. Yet, it is to be considered the first measure; other steps will follow.

That goes not only for the U.S., but also for Europe, where the European Central Bank uses a central interest of 1 percent and still actively supports the banking sector. Low interest rates currently support the economy and the financial sector. But they can, with time, also lead to inflation. Inflation is now very low almost everywhere, but the United Kingdom was already startled this week by inflation that turned out to have increased to above 3 percent. Australia was already working on tightening the reins monetarily. China is also busy reigning in the credit granting. It is to be expected that, if the economic recovery and the health of the financial sector allow it, central banks worldwide will normalize their policy.

That is to be applauded, but great caution and good communication are still needed. No one will benefit from more unnecessary unrest on the financial markets.