With a widely expected policy action, the Fed didn’t surprise us today. It raised its target range for the federal funds rate from 0 to ¼ percent to ¼ to ½ percent. Here are my thoughts:
- Normally, raising interest rates is a form of a contractionary monetary policy, meaning that the central bank believes the economy is overheated or strong enough, so that higher rates are necessary to prevent future excessive inflation. But this is not the case today. Inflation has been stubbornly low in the past few years, which is a big concern for the Fed. The FOMC today continued to lower its projection for inflation in the short term.
- Instead of fighting future inflation, the purpose of the policy action today is mainly to avoid hurting the Fed’s credibility by not delivering what was expected. Therefore, do not expect a continuous increase of rates, at least for the next couple of FOMC meetings (January, March 2016).
- If the ¼ to ½ percent target range for the federal funds rate is here to stay, the effect on different sectors of the economy will be very limited. A quarter of 1 percent raise is a tiny move compared with the FOMC’s longer term projection for the federal funds rate at 3.5 percent.
- If increasing interest rates is a long-term trend, then theoretically it will put constraints on consumption and investment. But it won’t happen right away. Empirically it has been shown that increasing interest rates, especially after a long low-interest period, impacts the real economy with lags. Consumers and investors see higher rates coming, and hence make purchases or investments now rather than later. Even if interest rates keep rising continuously, economic growth won’t get hit right away.
- With respect to the stock market, it will respond to the FOMC action immediately, but will be indifferent in the longer term. A study from AIER shows there is little correlation between stock market performance and the economy in the long run. Not responding to the current economic event may be the best strategy if you are not a daily trader.
- Last but not least, the fact that this move by the FOMC was widely expected shows that the Fed has changed its strategy from keeping policy decisions secret to being transparent. Going forward, we have a pretty good idea of what the Fed will do. The only question is when.
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