The Great Rate Debate
October 31, 2016
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.
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.
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.
- 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.
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%.
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.
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