The Fed’s Decision: On the Federal Funds Rate and Optimism

This Wednesday, December 16^th, members of the Federal Open Market Committee are widely expected to raise the Federal Funds rate—and with it, short-term interest rates—for the first time in nearly a decade.  While it is of course simple enough to come to an opinion when the choice seems much clearer—though many still remain skeptical of the appropriateness of a rate hike, and there are of course many risks and uncertainties—I am currently of the opinion that an interest rate increase is the proper course of action at this time.

While there are ongoing and vigorous debates in macroeconomics about the role of policy in the economy—in particular, whether fiscal and monetary policy are effective tools at all in a “policy-neutral” economy—there are several reasons why an announcement by Chair Yellen and the members of the FOMC regarding an increase in the Federal Funds rate is appropriate this Wednesday. I will try to list these reasons here, as well as acknowledge and potentially address some of the main concerns that arise with this potential action.

Why the Fed should raise rates:

• A higher Federal Funds rate is a sort of macroeconomic insurance policy, potentially pressing the brakes on the economy and slowing its momentum (the policy’s premium), but for the sake of more flexibility at a time when a stimulus policy is required (the payout).  Having an interest rate above 25 basis points provides a cushion and some wiggle room for potential further slowdowns.

• Whether we believe or not in the role of psychology and behavior in the strength of the economy, raising interest rates is a signal of confidence from the Fed in the economy, that may spur further confidence in the agents that participate in the economy itself. As learned in any introductory macroeconomics course, inflation (among other economic variables) can often be self-fulfilling. When people expect or believe the economy to be heating up, they may behave in a way that confirms and produces that very expectation.

• Most of the recent concern over the last few weeks has regarded falling commodity prices, which many see as a sign of weakness in the global economy. Coupled with still comparatively weak Eurozone and Chinese economies, many are concerned that we are still in a highly unstable situation. However, the Fed has expressed its belief that this downward pressure on inflation should abate with time. Naturally, there should be a floor to which prices of commodities—such as oil—should fall. When that process ends (at the time of this blog post, a barrel of crude oil is well below $40, as are its futures), there should in fact be an upward pressure on inflation. The performance of commodity prices should be seen as a temporary phenomenon, and one that is considerably supply-driven. As we know, production of crude oil by the United States is near record-highs, and the members of OPEC have not pared down their production targets to lower global supply. As such, falling commodity prices (in particular, oil) could be seen predominantly as a supply-driven phenomenon, which is less concerning in the immediate time span than the demand-driven view (where falling oil prices might signal a weakening in manufacturing, production, etc.).

• While financial stability is under the purview of the Federal Reserve, financial markets should not be the main consideration behind the Fed’s decisions. In fact, many of the notable movements over the last weeks in the prices of several important assets (the EURUSD exchange rate, bond yields, etc.) show that markets have long begun pricing in the effects of a rate hike, and widely expect the Fed to raise rates this Wednesday. Deciding otherwise at this point might be a negative signal on the strength of the economy. While there are of course valid concerns over the level of inflation, the labor markets and growth, the U.S. economy in particular is considerably healthier than it has been in nearly a decade (since the beginning of the recession in 2008 and the first rumblings of crisis in 2007).

• If we view inflation rates as tied (and potentially lagging) interest rates, raising the latter may in fact be a good way for the Fed to address concerns over disinflation and a potential deflationary spiral. Of course, we should not fall into the fallacy of believing that the Fisher equation—or generally the fact that interest rates and inflation rates are highly correlated—implies a causal relationship between these two variables. After all, the omitted variable here is likely that higher inflation rates follow a strong and vigorous economy, which may be accompanied by increasing interest rates as the Fed prevents overheating. But to the extent that prices follow increased costs of capital, and other factors provide a more causal relationship between interest rates and inflation, perhaps a hike in interest rates may help breathe further life into U.S. inflation.

• Wage growth, which has been closely observed as it is tied to and is a strong signal of inflation, should face upward pressure as the labor market tightens further. Concerns over the low labor participation rate are partly addressed by the beginning and continuing retirement of the large generation of baby boomers.

• "Creative destruction”: easy money makes risk-taking easier (the Fed is often blamed for not raising interest rates quickly enough in the years preceding the financial crisis of 2008, as low interest rates encouraged risk-taking in mortgages and other financial products), and allows for the inefficient survival of firms that—in a more competitive environment—would potentially go under. While the closing-down of firms and the subsequent loss of jobs is often not a positive development, if these firms are sluggish and inefficient, they can be a drag on the economy and prevent more innovative, entrepreneurial firms to take their place. Indeed, it can be as problematic to make running a business easy as it is to make it difficult; “creative destruction” entails that it is more optimal for inefficient businesses to not survive. Enabling them to survive means a weaker economy, less innovation, more complacency and deadweight losses on the economy. Less easy money and loans will mean literally “survival of the fittest” firms, which some might argue is how economies should thrive.

• Many have remarked on the abundance of excess reserves in banks. In a world where we perhaps see supply of loans (as opposed to demand) as the main driver of the amount of credit in the economy (meaning, a large determinant of how much loanable funds exist in the market is banks actually being willing to lend out money, which we saw was not the case during and immediately after the financial crisis), then raising rates may actually be an incentive for banks to increase their lending out processes, enabling a smooth flow of credit into the economy that might help counter any negative effects of a rate hike. Indeed, with higher interest rates the supply of loanable funds should increase, allowing us to increase our savings rate and, in the context of the Solow growth model, help propitiate a faster accumulation of capital.

• A slow, gradual tightening of policy should be good for the economy; the brakes need to be applied at some point and it’s better it be done smoothly and with warning (see criticisms of last crisis, how the Fed didn’t raise interest rates in time time). We wouldn’t want to raise rates too quickly, without warning, actually causing trouble for markets and consumers alike. The way the Fed has framed and given extensive forward guidance should ensure that expectations have been primed so as to avoid a major shock to the economy.

Of course, as with any other major policy action, there are significant risks and uncertainties. Perhaps the most cited concern by economists and commentators alike is a potential deflationary spiral, as an increase in interest rates provokes a slowdown in the economy (potentially a recession) and the vicious cycle of continuously falling prices (Japan presents a clear case-study).

To address this issue, it’s important to first gain some perspective. After all, the likely increase in interest rates is only a 25 basis point hike, which would then be followed by a slow, gradual increase that would likely follow the same guidelines the Fed has set with forward guidance.  Because of this new practice, in fact, the economy has absorbed and “priced in” the effect of this hike already. As such, this policy action should not actually be a “literal” shock to the economy.  Considering that many macroeconomic models view a role for unexpected shocks (for example, models like the Phillips curve, and generally rational expectations), the interest rate hike should ideally not have a major negative effect on the economy, as it has already been incorporated into our collective information set. Of course, this brings us tangentially to the topic of policy neutrality. After all, if the economy prices in and adjusts for this change in the first place, is the Fed actually able to provoke any changes in the real economy? That is a debate I’m likely not prepared to address—at least not at this time.

Another concern relates to the politics of the situation—some are concerned (on all sides of the political spectrum) that the Fed might provoke a change in the performance in the economy that will have real implications on the Presidential and Congressional elections next fall. To Democrats, a rate hike has the potential for a recession that would destroy any positive legacy regarding the Obama administration’s role in the recovery, and potentially make it more difficult for the Democratic nominee to win election to the White House (with all the subsequent policy implications that would entail). Republicans, on the other hand, are concerned that a delay in the interest rate hike would be a concerted ploy to aid the party in power by stimulating the economy further.

Of course, this concern should be easy (and highly critical) to assuage, as independence from political pressures is an incredibly important factor in the credibility of central banks and—in turn—the effectiveness of their policy actions and their ability to actually have an impact on the real economy. I think it should be clear enough that the Fed’s role is not to hamper or abet the political campaign of any one candidate or political party, and (while it might be necessary to do so) addressing these concerns directly might go too far in the way of granting validity to those who already criticize the Fed for lack of political independence. Validating these concerns is to accept that they are founded and pressing—which we would all like to think they are not.

Lastly, many are concerned about the dynamics of the Fed raising interest rates and, in turn, strengthening the value of the dollar, while the European Central Bank simultaneously continues and expands its own program of monetary stimulus that might further strengthen the USD. This, of course, plays into the recessionary fears, as a significantly strengthened dollar would reduce American exports, increase imports, and in turn, lower growth and GDP. However, this can also be seen as a positive for American consumers and for foreign investment, as the higher interest rates provoke a larger inflow of capital looking to invest in the United States.

I would like to end by once again providing some perspective, and perhaps some caveats. The action the members of the FOMC may take on Wednesday represents a long, careful deliberation process years in the making, and one that in the end may represent a comparatively small increase (likely 25 basis points) in the Federal Funds rate. Like with every policy action, there are risks and concerns. At some point, however, we must lift off. Now is looking better than it has in a while for it to happen.

This financial crisis and Great Recession has done a lot in the way of provoking a sense of pessimism and lack of confidence in the American and global economy. The repercussions of this crisis were indeed painful, far-reaching, and long-lasting, so any hesitation or skepticism at this time from both professional economists and laymen is understandable. Moreover, some may be concerned that the Fed is rushing into an action by simply trying to follow the psychological “clock” of moving early, before the end of the year is out. The turn of the calendar page could be seen as yet another failure—another year in which the economy has not fully and entirely recovered.

Yet, the economy has weathered both the original crisis and many other, smaller panics over the last years, and particularly over the last few months and weeks in the financial markets. I am confident in our policymakers, and optimistic that forward guidance should imply that with rational expectations, markets and consumers have absorbed all relevant rate hike information. Unemployment should not rise (especially given the strength in the labor market anyway), weak companies might be replaced by stronger and more innovative firms, and prices should follow the rise in interest rates as people ask for and obtain higher wages.

We can certainly expect some turbulence, but an increase in interest rates also represents a return to normalcy. In her testimony to Congress recently, Janet Yellen stated: “In closing, the economy has come a long way toward the FOMC's objectives of maximum employment and price stability. When the Committee begins to normalize the stance of policy, doing so will be a testament, also, to how far our economy has come in recovering from the effects of the financial crisis and the Great Recession. In that sense, it is a day that I expect we all are looking forward to.” Indeed, psychologically, Wednesday will be a day when we can all finally say: we made it.

After this entire discussion, the most important thing is that an interest rate hike perhaps means the return to one of the factors that’s been missing and, personally, I think is critical to the strength and performance of an economy: optimism. It is optimism that makes us move forward, take [healthy] risks, and progress. It is time for us to be optimistic about the economy once again, and Wednesday will hopefully be just a smooth and careful first baby step.