3… 2… 1… Liftoff!
October 25, 2015
Several years of moderate economic growth and growing indications from the Federal Open Market Committee (FOMC) have left the market asking when rather than if a “liftoff” of interest rates will occur. Many had predicted the September FOMC meeting would mark the first rate increase since December 2008 however the board members’ left the Federal funds rate unchanged at 0 to 0.25 percent citing reticence over low inflation and the sputtering global economy. While few people are predicting a rate increase at the October 27-28 meeting, consensus is that the U.S. Federal Reserve will raise its record-low interest rate for the first time in nearly a decade before the end of this year. With this in mind, the Wonk Tank Monetary and Fiscal Policy team decided to take the opportunity to provide some insight into the looming rate hike decision.
What decision is the FOMC making at their next meeting?
The primary responsibilities of the Federal Reserve System include: maximum employment, stable prices, and moderate long-term interest rates. The “decision” in question, is whether to raise the Federal funds rate – the interest rate at which banks lend funds maintained at the Federal Reserve overnight – for the first time since December 2008. Doing so affects not only short-term interbank loans but also short-term rates paid by firms and households as well as longer-term mortgages and corporate bonds. Effectively, this increases the cost of borrowing for banks, businesses, and individuals, which should act as a brake on rising inflation and an overheating economy. Fed Chair, Janet Yellen, has made abundantly clear that the rate increase would be gradual – no more than 0.25 percent at first – and timing more than anything else is the most critical component of the FOMC decision.
Who exactly is making this decision?
The FOMC is the most important monetary policymaking body of the Federal Reserve System as it is responsible for setting key interest rates and the buying and selling of government securities. The FOMC is comprised of twelve members including seven members of the Board of Governors of the Federal Reserve System and five Reserve Bank presidents.
The decision to change the Federal Funds Rate requires consensus. While past Chairs governed in a more authoritative manner Janet Yellen is known, on the other hand, for her consensus driven policy as described in a 2014 New Yorker profile. The same piece portrayed her as the kind of person who is always over-prepared, soft spoken, and some might say cautious all of which can help to better understand her thought process. While Yellen is known to be somewhat dovish, her tone has turned more hawkish in the past few months, which may be one of the strongest indicators of imminent “liftoff.” While the FOMC does not make the votes of each member public, they release dot plots with members’ interest rate predictions after each meeting.
What are the key factors that the FOMC is paying attention to when considering the timing of a rate increase?
Inflation: Inflation expectations lie at the center of the FOMC’s rate hike decision. Despite steady job creation, GDP growth, and rising wages, inflation has remained stubbornly near zero, a far cry from the Fed’s two percent long-term target. The disconnect between these macroeconomic indicators makes the timing of liftoff that much more uncertain. The September FOMC minutes point to concern that policy firming before it was clear that economic growth was clearly at above-trend pace could increase the downside risk to inflation. Those arguing for an increase sooner rather than later point out monetary policy’s lagging effect on the economy arguing that the Fed will have missed the right moment by continuing to delay.
Employment and Wage Growth: In theory, increases in the cost of labor (i.e. wages) puts upward pressure on prices of goods yet, as noted above, inflation remains well below the Fed’s long-term target. The U.S. is currently experiencing the longest private sector hiring spurt on record, which helped bring unemployment down to 5.1% from 5.3 percent over the summer. What’s more, real average hourly earnings increased by 2.2% from September 2014-2015. However, job growth of only 143,000 in September and 132,000 in August marked the weakest back-to-back months of job growth in nearly two years and, combined with a slowdown in wage growth (see chart), caused many to question the underlying strength of the recovery. This most recent data could be an anomaly stemming from a turbulent summer or it could be an inflection point signaling a downward trend in labor market conditions. Regardless, the uncertainty is without a doubt factoring into a cautious Yellen’s decision.
Energy and Commodity Prices: “Inflation, however has continued to run below our longer-run objective, partly reflecting declines in energy and import prices.” One needs only read the transcript of Yellen’s September FOMC remarks to comprehend how important a factor low energy and commodity prices are to the rate hike decision. The FOMC continues to reiterate their belief that as the effects of a decline in energy prices dissipate, inflation will gradually rise above the 2% objective. Again, the question at hand is timing. Interestingly, many initially believed that the decline in energy prices and the disposable income it provided to the American consumer would boost spending. However, Americans have yet to open their pocket books creating what almost Fed Chair Larry Summers calls a chronic excess of saving over investment.
Global Economic Events: According to Yellen, “While we expect the downward pressure on inflation from these factors will fade over time, recent global economic and financial developments are likely to put further downward pressure in the near-term.” Slowing growth in China continues to roil global markets as investors are unsure whether the Chinese government can outmaneuver market forces. What’s more, falling energy and commodity prices have cut into the growth of many emerging economies leading to fears of a slowdown of the global economy. Although U.S. economic data continues to generally meet market expectations, global economic growth concerns centered on China increased market volatility and reduced risk sentiment in the financial market. Some argue that the market has already done the tightening that an initial rate hike would have done.
Dollar Appreciation: Finally, the sharp appreciation of the USD relative to its major trading partners continues to place downward pressure on inflation. As energy and commodity prices have plummeted so have most emerging market currencies relative to the USD. The devaluation of the Renminbi did nothing to help. What’s more, the USD is a haven currency, which global investors flock to in times of economic uncertainty. The strong appreciation of the USD has dampened U.S. exports, effecting both growth and inflation. Raising interest rates would only make the USD more attractive to investors, especially as most other major currencies will continue to keep their key interest rates near, at, or even below zero.
Wonk Tank’s Thoughts?
It is important to keep in mind the lagging effect that the Fed monetary policy has on the U.S. economy. While inflation remains low for all the above reasons, “hot spots” are emerging in key sectors indicating that the economy is capable of handling a small initial rate increase. U.S. car sales are running at their fastest pace in a decade and commercial real estate prices have surpassed their bubble era peaks. Furthermore, the record low rates are beginning to cause financial distortions - think the rise of excess debt in parts of the corporate debt market - that could prove more dangerous to the economy than a rate hike. Bond market prices may no longer adequately reflect the risk inherent in high debt levels and the stock market has become artificially inflated as investors are forced into increasingly risky assets when seeking returns. That being said, timing still is the most critical component of the FOMC’s decision. The Fed must make the initial increase as small of a shock to markets as possible thus liftoff cannot come without warning. If I were a betting man, I would still go with December 2015. Then again, I thought the same thing about September.
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