The Federal Open Market Committee, the policy making arm of the Federal Reserve, explicitly points out in its October meeting statement that it will assess economic progress to determine whether it will raise the interest rate at its next meeting. The committee chose that language instead of saying “determine how long to maintain this target range” as it always has. The market took it as a signal of a December liftoff.
Given the fact that the U.S. economy is cooling down and other central banks are lowering interest rates, some might be curious about why we are even talking about raising interest rates.
The first reason for increasing the rate by year end is the long-formed market expectation. The FOMC has made an implicit commitment to raise interest rates by the end of 2015. Failing to deliver on that promise may undermine the Fed’s credibility.
Moreover, there are voices from the market questioning the Fed’s ability to raise the federal funds rate even it wants to. With the massive excess reserves in the banking system, the federal funds market is not functioning, and using the reverse repo rate and the interest rate on bank reserves may not be sufficient to bring the federal funds rate to the Fed’s target range. This would only give the Fed incentives to act in December and prove it can achieve its interest rate target.
Another, more important reason is that FOMC officials believe a lower unemployment rate will bring a higher inflation rate, and hence higher interest rates will be necessary to fight inflation. Indeed, the current unemployment rate is 5.1 percent, near full employment. But inflation has been sluggish, well below the Fed’s 2 percent target. Theoretically, low unemployment is accompanied by higher inflation, but historically, this has not always been the case. Going forward, we have no reason to assume such relationship will hold.
On the other hand, disappointing economic data have been flooding into the Fed’s plate: lack of wage growth, slowed GDP growth in the third quarter, lower consumer sentiment, businesses’ pessimism (reflected in the smaller inventories and slower hiring), the slowdown in the global economy s, the stronger U.S. dollar… the list goes on.
If defending its credibility is the primary reason for the initial rate increase, the Fed will only make a move in December by a small step, likely a 25-basis-point increase, and the pace afterward will be extremely slow. This small increase in the short-term interest rates shouldn’t have a big impact on businesses and consumers. In order to avoid a ripple effect, investors should try not to overreact to the Fed’s policy. In this case, no reaction may be the best reaction.