Friday, January 8, 2016

A brief note: Why the Fed should not have raised interest rates

Recently, the United States Federal Reserve decided to raise its key interest rate, the Federal Funds rate target, from 0%-.25% to .25%-.5%. This rise, while small, was not wise.

The federal funds rate is the benchmark rate for the Fed, decided by the FOMC(Federal Open Market Committee). The FOMC is made up of the 7 members of the federal reserve board, of which Janet Yellen is the head, and five federal reserve bank presidents, of which the president of the New York bank is always a member. It has control of key decisions, including raising the federal funds rate.

The federal funds rate is the rate at which banks and credit unions lend to other banks and credit unions over night without colateral. Lower interests rates result in cheaper borrowing, increasing consumer spending and investment, and thus aggregate demand, which results in higher inflation and GDP, as well as lower unemployment. Higher interests rates have the reverse effects.

There are a few reasons to raise interest rates. One is to lower inflation. However, as of now, this is not a problem. The Fed's target for inflation is 2%, but right now inflation is much lower. The Fed prefers the PCE price index to measure inflation. According to its most recent numbers total inflation increased .2% from a year earlier. However, this is unreliable because it includes volatile food and energy prices. Even when excluding them, inflation increased 1.3% from a year earlier. In fact, for over three years straight, inflation has been below the target. So as of right now, inflation is not high enough for concern.

Not only is inflation low, but there is little sign it will be of concern in the future, or even reach its target. Core inflation has been flat for several months, and the trend over the past few years is slightly down, not up. Wage growth is modest, but not high enough for worries about inflation.
In the period of solid growth, stretching from (January 2003-January 2007), average wage growth per month was about .34% in terms of average weekly earnings. Over the past year, average wage growth per month has been .17%. Clearly, wage growth is neither were it should be, nor does it indicate that there will be problematic inflation in the near future.

The economy, while recovering, is still not at full strength. I have already mentioned the lackluster wage growth. The U6, an alternate measure of labor underutilization and the one I prefer because it includes people who want a job but have stopped searching and people who want to work full time but can only find part time work, stood at 9.9% seasonally adjusted for the December 2015 jobs report. This is down significantly from its peak, and by an impressive amount from a year ago. However, it is still a couple percentage points above where it has been in past expansions (see previous posts). GDP growth is much lower than it has been historically during recent periods of robust growth.

The only other argument is fear of a bubble. At least in the U.S., however, this does not appear to be a problem. Housing prices are yet to recover from their peak. While the stock market is up significantly since its trough, it has stagnated in the past year. Continued low interest rates are not likely to cause a bubble, for the stock market had a correction with near zero interest rates. The most recent correction, occurring after the rate increase, while caused by a variety of factors, does not support the idea that the Fed made the right choice.

The problem with raising interest rates is that it makes borrowing more expensive. This reduces consumer spending and investment, which in turn increases unemployment and reduces growth. In fact, the last two major rate increases by western economies, Sweden in 2010 and the Euro-zone in 2011, were followed by interest rate decreases in the next few years because their economies struggled. While the U.S. economy now is stronger than either of those were, raising rates is still an unnecessary risk.

Overall, the feds interest rate rise is small, and definitely not catastrophic. However, with economic activity still not at full strength, it was not the right course of action either.

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