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The Great Rate Debate

October 31, 2016
Since the Great Recession, the United States Federal Reserve has pursued expansionary monetary policy characterized by low interest rates to incentivize borrowing and spending. Last December, it began to gradually increase rates from 0-0.25% to 0.25-0.50% with its first boost in nearly a decade. At that time, the Fed suggested that it would continue to raise interest rates another four times in 2016. However, this never happened, and when the Fed’s Board of Governors met this past September, it decided to leave rates as they are. As the presidential election looms closer, there has been growing speculation over when interest rates will increase. In this article, we take a closer look at the arguments for and against a future rate hike, and assess the likelihood of such an occurrence.

Reasons to Maintain Current Rates

Some of the reasons the Fed decided not to raise rates include that:

  • There are still many discouraged workers – people who have given up looking for jobs. Keeping the interest rate low, and therefore the unemployment rate low could incite these people to get back into the labor force.
  • Usually, keeping interest rates low increases inflation because consumption increases, which in turn increases wages and other prices. Because inflation has not yet reached targets, the the Fed has had less motivation to raise interest rates. According to Fed Chairwoman Janet Yellen, “The influence of labor market conditions on inflation in recent years seems to be weaker than had been commonly thought.” The graph below shows that the interest rate on a 10-year treasury bond is very low (the interest rates are low), yet inflation is also very low.

<em>(Image: Graph of CPI Inflation and 10-Year Nominal Treasury Yield. Data provided by Federal Reserve Board, BLS. Source: <a href="https://www.brookings.edu/wp-content/uploads/2015/03/30_interest_rates_inflation.png" target="_blank">Brookings Institute</a>)</em>(Image: Graph of CPI Inflation and 10-Year Nominal Treasury Yield. Data provided by Federal Reserve Board, BLS. Source: Brookings Institute)

  • The Fed’s job is to keep interest rates as close as possible to the market equilibrium real interest rate: the rate at which capital resources and labor are at full employment. As the economy has been recovering in the past few years, the equilibrium real interest rate has been very low, likely negative for some of that time. If the Fed raises rates too quickly, the resulting reduction in consumption could result in low returns on capital investment, thus forcing the Fed to again lower rates.

<em>(Image: Fed <span style="font-weight: 400;">Chairwoman Janet Yellen says that the Federal Reserve is in no hurry to raise interest rates. Source: <a href="http://www.nytimes.com/2015/02/25/business/economy/fed-chief-yellen-testifies-before-congress.html" target="_blank">The New York TImes/Stephen Crowley</a>)</span></em>(Image: Fed Chairwoman Janet Yellen says that the Federal Reserve is in no hurry to raise interest rates. Source: The New York TImes/Stephen Crowley)

That being said, it was a “close call” for some officials. There has been growing dissent over how much lower the unemployment rate can go before the economy overheats and inflation gets out of hand. Yellen argued for patience in raising rates, asserting that the labor market still had room to improve. In contrast, proponents of a rate hike, such as Eric Rosengren, President of the Federal Reserve Bank of Boston, claim that in order to remain at “full employment,” “gradual tightening” is appropriate.

Reasons to Raise Interest Rates

Proponents of a rate hike argue that:

  • A period of low interest rates from 2001-2006 is often cited as a contributing factor to the housing crisis of 2007. Such a period encourages both households and firms to heavily invest in highly-speculative financial instruments, such as mortgage-backed securities. Thomas Hoeing, current vice chairman of the Federal Deposit Insurance Corporation (FDIC) and former president of the Kansas City Federal Reserve Bank, argued that the reduced risk of failure, brought on partially by low interest rates, encouraged banks to take “excessive risks during the time leading up to the financial crisis of 2007-2008.

  • The current gap between savings deposits and required reserves encourages banks to invest in securities that may contribute to this bubble. Due to changes in the Fed’s own policies and additional measures introduced by the Dodd-Frank Wall Street Reform Act, the required reserves of banks have increased considerably since the financial crisis. According to the Federal Reserve Economic Database (FRED), the gross private saving of the United States has increased 51.4% from $2,470.1 billion as of the first quarter of 2008 to $3,738.5 billion as of the first quarter of 2016. However, the required reserve balances have increased by 1,275.3% from $7,017 billion to $96,507 billion in the same amount of time.

<em>(Image: Graph of required reserves and savings since 2008. Source: FRED)</em>(Image: Graph of required reserves and savings since 2008. Source: FRED)

  • This gap is partially responsible for an uncertain stock market that trades heavily on the whims of the Federal Reserve. According to Yellen, “Our experience suggests that it’s hard to have great confidence in predicting what the market reaction will be to Fed decisions… we can only do what is in our power to attempt to minimize needless volatility that could have repercussions for other countries or for financial stability more generally.” The following chart shows how the market reacts to public statements made by the Federal Reserve. Notice how announcements hinting at lowering rates or retaining current rates tend to result in an increase in the Dow Jones, whereas announcements hinting at a rate hike often result in a decrease of the Dow Jones.

<em>(Image: Graph of Dow Jones Industrial Average with Federal Reserve Interest Rate Announcements indicated. Source: FRED)</em>(Image: Graph of Dow Jones Industrial Average with Federal Reserve Interest Rate Announcements indicated. Source: FRED)

  • All of these factors point to a bubble building in the market for financial instruments, particularly in the stock market. Raising interest rates could help to prevent such a bubble by encouraging average American consumers, who currently have little incentive to save, to put more of their income into their savings accounts. This would help close the gap between deposits and required reserves and, in turn, reduce market-driven speculation.

The Future of Rate Hikes

Throughout this year, the Fed’s hesitance to enact a rate hike can largely be explained by sluggish economic recovery and low inflation. For example, in March, the Fed set a target federal funds rate of 0.875% for the end of 2016, 1.875% for the end of 2017, and 3.000% for the end of 2018. But this now seems too ambitious: in light of last month’s decision, it seems that the Fed will, at most, enact one 0.25% rate hike by the end of this year, resulting in a rate of 0.625%.

<em>(Image: <span style="font-weight: 400;">Rate predictions from June placed the target for the end of 2016 at 0.9% (unlikely after September's decision), 1.6% </span><span style="font-weight: 400;">at the end of 2017, and 2.4% at the end of 2018. These figures, with the exception of 2016, are all smaller than their </span><span style="font-weight: 400;">March counterparts. Source: <a href="https://www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20160615.pdf" target="_blank">Federal Reserve</a>)</span></em>(Image: Rate predictions from June placed the target for the end of 2016 at 0.9% (unlikely after September's decision), 1.6% at the end of 2017, and 2.4% at the end of 2018. These figures, with the exception of 2016, are all smaller than their March counterparts. Source: Federal Reserve)

Despite the Fed’s overall hesitance to raise rates, there are some in the monetary policy community, such as Vice Chairman Stanley Fischer, who have suggested that some combination of spending or tax cuts could sustain a rate hike. The proposal’s boon to consumption would in turn raise equilibrium rates, accommodating a rate hike and offsetting the negative effects on consumption incurred by this increase. However, after last month’s decision, a rate hike will at least have to wait until December.

Student Blog Disclaimer
  • The views expressed on the Student Blog are the author’s opinions and don’t necessarily represent the Penn Wharton Public Policy Initiative’s strategies, recommendations, or opinions.

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RESOURCE SPOTLIGHT:

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  • <h3>Congressional Budget Office</h3><p><img width="180" height="180" alt="" src="/live/image/gid/4/width/180/height/180/380_cbo-logo.rev.1406822035.jpg" class="lw_image lw_image380 lw_align_right" data-max-w="180" data-max-h="180"/>Since its founding in 1974, the Congressional Budget Office (CBO) has produced independent analyses of budgetary and economic issues to support the Congressional budget process.</p><p> The agency is strictly nonpartisan and conducts objective, impartial analysis, which is evident in each of the dozens of reports and hundreds of cost estimates that its economists and policy analysts produce each year. CBO does not make policy recommendations, and each report and cost estimate discloses the agency’s assumptions and methodologies. <strong>CBO provides budgetary and economic information in a variety of ways and at various points in the legislative process.</strong> Products include baseline budget projections and economic forecasts, analysis of the President’s budget, cost estimates, analysis of federal mandates, working papers, and more.</p><p> Quick link to Products page: <a href="http://www.cbo.gov/about/our-products" target="_blank">http://www.cbo.gov/about/our-products</a></p><p> Quick link to Topics: <a href="http://www.cbo.gov/topics" target="_blank">http://www.cbo.gov/topics</a></p><p>See all <a href="/data-resources/">data and resources</a> »</p>
  • <h3>Federal Aviation Administration: Accident & Incident Data</h3><p><img width="100" height="100" alt="" src="/live/image/gid/4/width/100/height/100/80_faa-logo.rev.1402681347.jpg" class="lw_image lw_image80 lw_align_left" srcset="/live/image/scale/2x/gid/4/width/100/height/100/80_faa-logo.rev.1402681347.jpg 2x, /live/image/scale/3x/gid/4/width/100/height/100/80_faa-logo.rev.1402681347.jpg 3x" data-max-w="550" data-max-h="550"/>The NTSB issues an accident report following each investigation. These reports are available online for reports issued since 1996, with older reports coming online soon. The reports listing is sortable by the event date, report date, city, and state.</p><p> Quick link: <a href="http://www.faa.gov/data_research/accident_incident/" target="_blank">http://www.faa.gov/data_research/accident_incident/</a></p><p>See all <a href="/data-resources/">data and resources</a> »</p>
  • <h3>USDA Nutrition Assistance Data</h3><p><img width="180" height="124" alt="" src="/live/image/gid/4/width/180/height/124/485_usda_logo.rev.1407789238.jpg" class="lw_image lw_image485 lw_align_right" srcset="/live/image/scale/2x/gid/4/width/180/height/124/485_usda_logo.rev.1407789238.jpg 2x, /live/image/scale/3x/gid/4/width/180/height/124/485_usda_logo.rev.1407789238.jpg 3x" data-max-w="1233" data-max-h="850"/>Data and research regarding the following <strong>USDA Nutrition Assistance</strong> programs are available through this site:</p><ul><li>Supplemental Nutrition Assistance Program (SNAP) </li><li>Food Distribution Programs </li><li>School Meals </li><li>Women, Infants and Children </li></ul><p> Quick link: <a href="http://www.fns.usda.gov/data-and-statistics" target="_blank">http://www.fns.usda.gov/data-and-statistics</a></p><p>See all <a href="/data-resources/">data and resources</a> »</p>
  • <h3>National Center for Education Statistics</h3><p><strong><img width="400" height="80" alt="" src="/live/image/gid/4/width/400/height/80/479_nces.rev.1407787656.jpg" class="lw_image lw_image479 lw_align_right" data-max-w="400" data-max-h="80"/>The National Center for Education Statistics (NCES) is the primary federal entity for collecting and analyzing data related to education in the U.S. and other nations.</strong> NCES is located within the U.S. Department of Education and the Institute of Education Sciences. NCES has an extensive Statistical Standards Program that consults and advises on methodological and statistical aspects involved in the design, collection, and analysis of data collections in the Center. To learn more about the NCES, <a href="http://nces.ed.gov/about/" target="_blank">click here</a>.</p><p> Quick link to NCES Data Tools: <a href="http://nces.ed.gov/datatools/index.asp?DataToolSectionID=4" target="_blank">http://nces.ed.gov/datatools/index.asp?DataToolSectionID=4</a></p><p> Quick link to Quick Tables and Figures: <a href="http://nces.ed.gov/quicktables/" target="_blank">http://nces.ed.gov/quicktables/</a></p><p> Quick link to NCES Fast Facts (Note: The primary purpose of the Fast Facts website is to provide users with concise information on a range of educational issues, from early childhood to adult learning.): <a href="http://nces.ed.gov/fastfacts/" target="_blank">http://nces.ed.gov/fastfacts/#</a></p><p>See all <a href="/data-resources/">data and resources</a> »</p>
  • <h3>The World Bank Data (U.S.)</h3><p><img width="130" height="118" alt="" src="/live/image/gid/4/width/130/height/118/484_world-bank-logo.rev.1407788945.jpg" class="lw_image lw_image484 lw_align_left" srcset="/live/image/scale/2x/gid/4/width/130/height/118/484_world-bank-logo.rev.1407788945.jpg 2x, /live/image/scale/3x/gid/4/width/130/height/118/484_world-bank-logo.rev.1407788945.jpg 3x" data-max-w="1406" data-max-h="1275"/>The <strong>World Bank</strong> provides World Development Indicators, Surveys, and data on Finances and Climate Change.</p><p> Quick link: <a href="http://data.worldbank.org/country/united-states" target="_blank">http://data.worldbank.org/country/united-states</a></p><p>See all <a href="/data-resources/">data and resources</a> »</p>
  • <h3>NOAA National Climatic Data Center</h3><p><img width="200" height="198" alt="" src="/live/image/gid/4/width/200/height/198/483_noaa_logo.rev.1407788692.jpg" class="lw_image lw_image483 lw_align_left" srcset="/live/image/scale/2x/gid/4/width/200/height/198/483_noaa_logo.rev.1407788692.jpg 2x, /live/image/scale/3x/gid/4/width/200/height/198/483_noaa_logo.rev.1407788692.jpg 3x" data-max-w="954" data-max-h="945"/>NOAA’s National Climatic Data Center (NCDC) is responsible for preserving, monitoring, assessing, and providing public access to the Nation’s treasure of <strong>climate and historical weather data and information</strong>.</p><p> Quick link to home page: <a href="http://www.ncdc.noaa.gov/" target="_blank">http://www.ncdc.noaa.gov/</a></p><p> Quick link to NCDC’s climate and weather datasets, products, and various web pages and resources: <a href="http://www.ncdc.noaa.gov/data-access/quick-links" target="_blank">http://www.ncdc.noaa.gov/data-access/quick-links</a></p><p> Quick link to Text & Map Search: <a href="http://www.ncdc.noaa.gov/cdo-web/" target="_blank">http://www.ncdc.noaa.gov/cdo-web/</a></p><p>See all <a href="/data-resources/">data and resources</a> »</p>