Interest rates are low. The economy is growing! All’s well on the economic front … right? Well, not exactly. Troubling signs lurk not far under the surface that America—and the rest of the world with it—is headed for a major recession.
U.S. interest rates have been dropping constantly for the past few years, even since the economy began bouncing back in October 2001. As the economy has kept growing, interest rates have kept going down—at least until now. But though the Federal Reserve raised interest rates in June to 1.25 percent, up from the 1 percent they had been for a year, there are side effects of having left interest rates so low for so long.
One significant side effect is the increase in home values. This has led many Americans to refinance and borrow more money. But now, since the housing market is over-inflated, home prices are likely to drop. If the housing bubble collapses, homes will lose value and people will end up owing much more in proportion to what their home is worth.
The Fed is very aware of the dangers of too much inflation; interest rates are usually raised to curb the problem. But the prolonged low rates now have the Federal Reserve in a bind. If it raises rates quickly, variable mortgage rates will rise, and homeowners will have less to spend, since their monthly home payments will increase. If the Fed does not raise rates, the bubble will only grow larger. The problem is, the inevitable has already been delayed too long.
It looks unlikely that the Fed will raise interest rates quickly, especially in light of the coming presidential elections. Such a move would certainly start a recession.
But of course, keeping interest rates low is no solution either. With inflation rising, prices will soon outstrip demand, just as has occurred historically. Then we would enter a period of deflation, and recession.
In times of economic difficulty in the past, such as during the 2001 mini-recession, America was able to stay afloat largely by lowering interest rates significantly. That option is not available now if the U.S. slips into a recession, because this option to stimulate the economy has already been spent.
So how does this affect the world economy? Consumer spending accounts for about 70 percent of the U.S. economy (Bloomberg). Other nations depend on American consumers to fuel their economies by buying their exports. If America enters a serious recession, it’s certain that most of the world will follow along with it. The bubble is getting bigger and bigger—but the burst cannot be delayed forever.