Fed rate hikes don't just fight inflation. They hurt economy over long-term, study says

Hiking interest rates aggressively, as the Federal Reserve has done over the past 14 months, doesn’t just fight inflation by tamping down economic growth in the short term.

The strategy also curtails the economy’s output and growth potential over the long run by discouraging innovation, according to a paper set to be presented Friday at the Fed’s annual conference in Jackson Hole, Wyoming.

“Our findings suggest that monetary policy may affect the productive capacity of the economy in the longer term,” states the study by Yueran Ma and Kaspar Zimmermann, economics and finance professors at the University of Chicago. “A slower pace of innovation may then have lasting effects.”

Broadly, a percentage point increase in interest rates could reduce economic output by 1% up to nine years later, the authors say. Since the Fed has raised its key interest rate by 5.25 percentage points since March 2022, that suggests the campaign could lead to a 5% reduction in output in coming years.

With inflation easing but still high and economic and job growth remaining sturdy, Fed officials are debating whether to raise rates again this year or hold them steady to avoid a possible recession.

The study, however, doesn’t conclude that the Fed necessarily should refrain from raising rates if needed to contain inflation. Rather, it suggests that increased government funding for innovation could offset the rate increases.

What happens to long-run economic growth when interest rates increase?

Economists traditionally have believed that the economy’s long-term potential isn’t affected by lifting interest rates to corral inflation or lowering them to stimulate weak growth, the paper says. But that 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. That can make it less profitable for companies to develop new offerings and come up with innovations that increase efficiency and spark faster growth, the paper says.

Sharply rising rates also can lead to less favorable financial conditions. That means it becomes more expensive to take out a loan to launch a new product or business, the stock market is down and investors are more likely to put their money in safe bonds that now pay a higher interest rate than take a chance on a new venture.

A percentage point interest rate rise can cut research and development spending by 1% to 3% in one to three years, the study says. In the same time frame, venture capital investment falls by 25%. And patents for new inventions decline by up to 9% in two to four years, the study says.

An aggregate innovation index based on the economic value of patents also slides by 9% in that period, leading to a 1% drop in output five years later.

How high did the Fed raise interest rates?

The effects could be more pronounced in the current rate-hiking cycle since the Fed has jacked up its benchmark rate by more than 5 percentage points from near zero in an effort to tame a historic inflation spike. Since the hikes began in March 2022, venture capital investment has fallen from its 2021 peak by about 30% annually, the study says. The retreat has affected all major sectors, not just those “sometimes perceived as speculative bubbles,” such as cryptocurrencies.

Investment in generative AI (artificial intelligence) has rebounded this year, but that mostly has been fueled by Microsoft’s $10 billion investment in OpenAI, the paper says.

Meanwhile, the dropoff in patents impacts both public and private companies as well as large and small ones, the study says. However, since large public firms have more financial resources, their pullback in innovation is likely driven more by softer customer demand than unfavorable financial conditions.

What happened to interest rates in the late 1970s and early 1980s

Fed rate hikes don’t always discourage innovation, the study says. When computers took off in the 1970s and 1980s, inflation and interest rates were high but technological developments were so dramatic that the rate increases had just a marginal effect, the study says.

And the authors don't urge the Fed necessarily to hold off on further rate increases or move quickly to cut rates.

“We do not think our findings necessarily imply that monetary policy should be more dovish,” meaning geared more to lowering than raising rates, the study says.

Instead, the authors say, government programs could provide companies grants or subsidies to bolster innovation if the economy is struggling or interest rates are rising.