Regarding the fed’s recent decision to raise interest rates:
- Why now and not before?
- Is it enough to make a difference?
- If it is, what difference, inside and outside US?
Before getting to the questions let’s take a look at the purpose and goal of the fed so we can look at some of the trade-offs they are dealing with. The fed has pretty much three goals:
The balancing act that the fed aims to achieve is to provide enough money to keep unemployment low, without creating too much inflation and losing control of prices. The fed does provide some guidance on what it considers to be appropriate levels of these indicators. For inflation the current target is 2%. Or in fed-speak:
“The FOMC noted in its statement that the Committee judges that inflation at the rate of 2 percent (as measured by the annual change in the price index for personal consumption expenditures, or PCE) is most consistent over the longer run with the Federal Reserve’s statutory mandate.”
There is no exact target for unemployment. Estimates of the long run normal rate of unemployment among members of the FOMC range between 4.7 to 5.8 percent, however these estimates are clustered at the lower end of the range, with the median value at 4.9. Ultimately, the Fed is looking for inflation to be around 2% and unemployment to be about 5%. It is important to keep in mind that the fed looks to as long term goals. So just because the inflation rate is below 2% at the moment does not necessarily mean that the fed will not raise interest rates, if it predicts an increase in the inflation rate in the future.
Why now and not before?
For all of the quantitative tools and extensive analysis at their disposal, monetary policy remains an art not a science. The FOMC meets eight times a year to decide if they want to change interests rates. Each time they meet they publish a brief press release regarding their decision. Comparing the two most recent statements will help give a sense of what changed. Here is the one from the second most recent meeting in October of 2015.
It begins with an overall description of the current economic situation.
“Information received since the Federal Open Market Committee met in September suggests that economic activity has been expanding at a moderate pace. Household spending and business fixed investment have been increasing at solid rates in recent months, and the housing sector has improved further; however, net exports have been soft.”
Then it starts talking about unemployment.
“The pace of job gains slowed and the unemployment rate held steady. Nonetheless, labor market indicators, on balance, show that underutilization of labor resources has diminished since early this year.”
Job growth slowed since their last meeting, and the unemployment rate did not change. However, things are better than they were at the beginning of the year. Since the unemployment rate did not decline, the fed sees evidence that they should carry on with their current policy.
“Inflation has continued to run below the Committee’s longer-run objective, partly reflecting declines in energy prices and in prices of non-energy imports. Market-based measures of inflation compensation moved slightly lower; survey-based measures of longer-term inflation expectations have remained stable.”
Again, no major changes. Inflation is below where the Fed would like it to be, so as far as the current situation is concerned there isn’t a huge need to change monetary policy to reduce inflation.
Then the fed talks about its expectations for the future. This is important. Monetary policy is not an instant tool, so the fed really needs to base its decisions on what it thinks inflation and unemployment are going to be down the road.
“Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability. The Committee expects that, with appropriate policy accommodation, economic activity will expand at a moderate pace, with labor market indicators continuing to move toward levels the Committee judges consistent with its dual mandate. The Committee continues to see the risks to the outlook for economic activity and the labor market as nearly balanced but is monitoring global economic and financial developments. Inflation is anticipated to remain near its recent low level in the near term but the Committee expects inflation to rise gradually toward 2 percent over the medium term as the labor market improves further and the transitory effects of declines in energy and import prices dissipate. The Committee continues to monitor inflation developments closely.”
Even though currently unemployment is above the target and inflation is below, the Fed predicts that the labor market will gradually improve and that inflation will gradually rise.
Then the Fed goes on to make the call about not to change the federal funds rate.
“To support continued progress toward maximum employment and price stability, the Committee today reaffirmed its view that the current 0 to 1/4 percent target range for the federal funds rate remains appropriate.”
Contrasting this with the latest press release where they explain their decision to raise interest rates and what changed.
“Information received since the Federal Open Market Committee met in October suggests that economic activity has been expanding at a moderate pace. Household spending and business fixed investment have been increasing at solid rates in recent months, and the housing sector has improved further; however, net exports have been soft. A range of recent labor market indicators, including ongoing job gains and declining unemployment, shows further improvement and confirms that underutilization of labor resources has diminished appreciably since early this year. Inflation has continued to run below the Committee’s 2 percent longer-run objective, partly reflecting declines in energy prices and in prices of non-energy imports. Market-based measures of inflation compensation remain low; some survey-based measures of longer-term inflation expectations have edged down.”
This is a stronger characterization of the economy than the previous month’s report, especially regarding changes in the labor market. Which, due to their mandate, is one of the things the Fed is most concerned with.
“The Committee judges that there has been considerable improvement in labor market conditions this year, and it is reasonably confident that inflation will rise, over the medium term, to its 2 percent objective. Given the economic outlook, and recognizing the time it takes for policy actions to affect future economic outcomes, the Committee decided to raise the target range for the federal funds rate to 1/4 to 1/2 percent.”
This is where the FOMC makes the call to raise interest rates. They have been waiting for labor market conditions to improve to the point where they can raise interest rates without too much risk to the labor market. They believe that the labor market is now at that level.
“The stance of monetary policy remains accommodative after this increase, thereby supporting further improvement in labor market conditions and a return to 2 percent inflation.”
Even though they did raise interest rates for the first time since 2006, they didn’t raise them very much and they remain very low by historical levels. Although there have been near-zero interest rates for several years now it is important to keep in mind that they are historically abnormal. Some people have characterized this decision as lifting up on the gas pedal a little bit instead of keeping it hard pressed to the floor. This is probably not a bad way to think about the change the FOMC has made.
Because of the way these decisions are made, the impact of interests rates, the huge variety of indicators that need to be taken into account, as well as different political viewpoints, there will always be people who believe that the fed should have waited, or should have raised interest rates earlier. The timing of the federal reserve’s move is not something I have an opinion on.
- Is it enough to make a difference?
- If it is, what difference, inside and outside US?
A difference in what? Interest rates have an incredibly broad impact on the economy. I assure you that there will be something that is affected by this change. In the most basic terms, an increase in interest rates raises the costs of borrowing money, this should reduce economic growth, job growth, and most asset prices, along with a myriad of other impacts.
As far as international impacts go, US government debt serves as a reference point for the global economy, so fed interest rate decisions do have global impacts. One impact is a likely appreciate of the US dollar, which has its own global feedback effects.
That said, the changes from this particular raise are likely to be fairly minimal. This was a small change, and one that was expected by financial markets. Expectations matter when it comes to interest rate changes, and this change was already pretty much priced into financial markets. It is important to remember that the fed will likely continue to increase rates going forward. This isn’t the end of anything, it’s a process that will continue. Most forecasts have interest rates rising to something like 1-2 percent in the next couple of years. Predicting the global economy is a tricky thing to do, so I’m going to refrain from guessing at specific impacts of future rate increases.
 Federal Open Markets Committee. Bit of the Federal reserve that actually gets together to decide what interest rates should be.
 In general, I don’t like analogies that equate the economy to anything like an airplane or a car. The economy is not a thing, and is much more complicated and unpredictable than any airplane.