Is something big happening at the Federal Reserve this week?
Yup. The federal open market committee (FOMC) is meeting from Tuesday 15 December to Wednesday 16 December. During that time, members of the committee will discuss the unemployment situation, inflation and the global economy to determine if the US economy is strong enough for an interest-rate hike. They will announce their decision on Wednesday.
Well, is the economy strong enough for a rate hike?
According to the Federal Reserve chair, Janet Yellen, probably. The Fed has two main aims with interest rates – to encourage investment and job creation, and to control inflation. The unemployment rate is at 5% and in her testimony to Congress earlier this month, Yellen said she was also confident that inflation would return to 2%, which is the Fed’s target.
These all sound like good things. Why do we need to change things?
There are signs that the US economy is – finally – shaking off the aftermath of 2008’s recession. Part of that recovery was possible because the Fed kept the interest rates near zero. The opponents of interest-rate hikes want the Fed to hold off so that the economy can get even better. But the Fed is trying to do quite a balancing act here. We have been living in extraordinary times and the Fed wants to move back to more ordinary ones. If it waits too long there is the possibility that some markets will overheat (remember the housing bubble?) or inflation will take off.
Over the past few months, Yellen has been making a case for a gradual increase in interest rates – warning against an abrupt “tightening policy”. “[A]n abrupt tightening would risk disrupting financial markets and perhaps even inadvertently push the economy into recession,” she said at the beginning of this month.
Here is a handy list of pros and cons from The Economist.
When was the last time they increased interest rates? Isn’t the Fed used to making these calls?
The last time interest rates were raised was June 2006, a year before Apple rolled out the original iPhone. A whole generation of people have grown up with the idea that interest rates are close to zero. Yellen’s predecessor, Ben Bernanke, raised rates just once in his entire tenure.
I get that this is a big deal, but … what exactly happens when the Fed raises interest rates?
According to Gus Faucher, senior macroeconomist at PNC Financial Services Group, there are two particular rates the Fed would look to increase.
The first is the federal funds rate: that’s the rate that banks charge one another for overnight loans. The second is the interest rate on excess reserves, which the Fed pays to banks that have funds deposited at the Fed in excess of those funds required under law. The key is that these are very short-term rates. Any changes the Fed make will have little impact on longer-term rates, such as 30-year mortgage loans.
Banks are likely to raise the prime rate (charged to their best corporate customers for short-term loans) to 3.25% to 3.50% in response to the Fed move. Other rates that are based on prime (including some on credit cards and some for student loans) will thus increase when the FOMC raises the Fed funds rate. Shorter-term rates, such as three-year car loans and lines of credit, will go up by more than longer-term rates.
Faucher pointed out that the rate hike will be slow and change will be gradual. He expects the interest rate to go up .25 percentage points this month. This hike would be followed by three more such hikes in 2016.
“We expect the Fed funds rate to move up by 1 percentage [point] through the end of 2016,” he said.
Most Americans have fixed-rate mortgages, so don’t expect those rates to zoom up. But they will rise, as will the cost of borrowing for everyone, including Wall Street. The end of all that easy money will come slowly, but it could have a profound impact on an economy that has grown used to rock-bottom interest rates.
Hold on. This sounds like I am not going to be making any money off this rate hike. Credit card interest rates are going up and so are student loans and car loans. What’s in this for me?
Depends where your money is – or if you have saved anything at all, anywhere.
“If you have all your money in bank accounts/short-term money funds, you should start seeing more returns. However, if you own longer-term bonds, you could see some losses on the principal if yields rise,” explained Jim O’Sullivan, chief US economist at High Frequency Economics. “Equities could go up or down based on history, although my guess is that Fed tightening is at least a bit of a negative for equities.”
Is there anyone who does not think we should raise interest rates?
Elise Gould of the left-leaning Economic Policy Institute believes the Fed should hold off for a while and wait until there are more full-time, better-paying jobs. After the US Department of Labor announced that the US economy had created 211,000 jobs in November and that the US unemployment rate remained at 5%, she said:
We won’t be at full employment until we see durable acceleration of wage growth, and only once we have achieved full employment will all workers be able to get the jobs they need and the hours they want, and be better positioned to negotiate for higher pay. Yes, interest rates have been low for a long time, but the Fed should not raise rates simply to scratch a seven-year itch.
The Fed, however, considers a 5% unemployment rate to be pretty close to full employment.
Wasn’t there also a guy who said it was unnatural for things – including interest rates – to rise in the fall?
You are thinking of California congressman Brad Sherman, who told Yellen:
God’s plan is not for things to rise in the autumn, as a matter of fact, that’s why we call it fall, nor is it God’s plan for things to rise in the winter, through the snow. God’s plan is that things rise in the spring. And so if you want to be good with the Almighty, you might want to delay until May.
For anyone who was not certain, the congressman later clarified that his remarks were a joke:
OK, we have covered jokes and analysis. Is there anything else that I need to know?
Well, before the September press conference, traders were passing around Yellen’s horoscope. So maybe check that come Wednesday morning. Here is Yellen’s forecast from this week (she’s a Leo, by the way): “Do not be afraid of change, accept it readily.”
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