On Dec 14, the Federal Open Market Committee, led by their Chair Janet Yellen, voted to raise the base interest rate, the Federal Funds Rate, by 25 basis points (or 0.25%) to a range of 0.50% to 0.75%. While this may not sound like a big deal, there are large implications that, like any big decision, makes it a hot topic for debate. If nothing else, the fact that this is the first time since last December that rates have been raised (which was also at 0.25%), and only the second time in over 10 years, shows that it’s an action taken with a lot of care (or that they’re just too lazy to do it more often). So why raise rates now, and why only 25 points? Before we take a dive into the minds of the Almighty Janet and The Yellenites, let’s do a little overview of what this all means.
Janet Yellen, as mentioned, is the Chair of the Federal Open Market Committee (FOMC), which is the monetary policymaking body of the Federal Reserve System. They meet eight times each year with the goal of ensuring maximum employment and stable prices across the U.S. economy; their favorite tools being a manipulation of the Federal Funds Rate (as discussed in a previous article) and the purchase and sale of Treasury-backed securities (something that they have done on a very large-scale since 2008). When the FOMC decides to change the Federal Funds Rate, it sends “tremors” throughout the economy in the form of (mostly) proportionate changes in the rates that we see everyday: anything from the 10-year U.S. Treasury, to mortgage rates, to the interest rate you receive in your savings account.
What do these tremors cause? The idea (loose phrasing, because few in economics dare say that a law holds 100% of the time) is that when rates are lowered, they encourage spending (since borrowing is cheaper), which increases economic activity. When rates are raised, spending is discouraged (due to more expensive borrowing), thus decreasing economic activity. So, if rates are increased, as they were just a few days ago, it would be more expensive to buy that house because you would spend more to cover the interest on the mortgage; and if all mortgages are more expensive today than they were on December 1st, many people may be discouraged from buying. It is here that we see an interplay with supply and demand: on December 1st, mortgages are “cheap,” people buy houses, and the law of supply and demand says that prices of homes will go up (A.K.A. an inflation of housing prices). On December 15th (the day after the rates are raised), mortgages are “expensive,” and the housing prices will decrease (A.K.A. a deflation of housing prices).
While housing is a good example, it can be applied to many different microcosms of the economy, which brings us to the idea of the velocity of money, which can be defined as the turnover of the money supply. In other words, the velocity of money is how many times a single dollar is spent in a given period of time (or how quickly it moves from one transaction to another). If rates are high, a dollar may not travel quickly due to individuals and businesses tightening their belts along the way, making the dollar sit in one place until it ‘needs to be spent.’ Therefore, the longer it takes for the dollar to be spent, the slower the velocity of money, and the slower the economy (lower growth and lower inflation).
Wait a second. Raising rates leads to a slower economy?? What the heck!? Why would Almighty Janet and The Yellenites want to slow down the economy?
Well, based on data gathered on the state of the economy on a continual basis, the FOMC decided that the economy may be growing at too fast a rate, and that ‘cooling it down’ would stabilize prices (part of the committee’s overall mission). The analysis tends to favor the Personal Consumption Expenditures Index, which is the measure of price changes of consumer goods (both durable and non-durable) and services. For quite some time, the FOMC had repeatedly stated that, in order to raise rates, they were waiting on the PCE to indicate inflation at a rate of 2% and an increase in wages (due to higher demand for labor, which results from low unemployment); these two measures also in lead to higher levels of consumer sentiment and consumer wealth.
Long story short: PCE only indicated inflation of 1.7%, while wages increased (arbitrary, I know, that’s as far as they were willing to take it). So why raise rates anyway? The consensus of the FOMC members is that perhaps there’s a bit of lag between their actions and the change to be reflected in the economy. Put another way: raise rates today, curb inflation next year. Does this sound a legit? Sure. Is it? Well, it’s hard to say for sure (a stance Yellen loves to take). The FOMC stated that, despite the PCE indicating low levels of inflation, the year-over-year change in the index was approximately 1%, indicating a quickly moving upward trend. Furthermore, projections from individual members of the FOMC for inflation-adjusted GDP in 2017 was at 2.1%, indicating that the economy should be at target pace soon.
Since our economy is tied to our political environment (for better or worse), there is a notion that, due to his promises on the campaign-trail, the economy may see faster growth after our new president is sworn in. As The Wall Street Journal put it, “the election of President-elect Donald J. Trump has prompted many economists to adjust their forecasts for the years ahead. In anticipation of what could be substantial fiscal stimulus (in the form of tax cuts and infrastructure spending), economists have collectively raised their forecasts for economic growth, inflation and interest rates.” By lowering corporate taxes and spending more on our country’s infrastructure, we may see the economy (and inflation) increase by a larger degree than already anticipated. So, is the move well-timed?
Prescribing to the idea of the FOMC delivering a delayed kick to the shorts of the U.S. economy, pulling the trigger before the economy gets “too hot” may save the day (…tomorrow). However, the fear is that the FOMC may have jumped the gun, which may end up stifling an already weak economy. It is said that the best way to gauge sentiment is to ask the ‘regular people’ around you (that means that Uncle Joe, the award-winning economist, is out of the running). To inject a bit of personal opinion based on the people in my life, the economy is improving, but I wouldn’t necessarily label it as “runaway inflation.”.
As for where we are now? I guess we’ll see over the next few months as the FOMC prepares for three more rate hikes. Let’s just hope that Yellen is better at this job than Lucy was in the chocolate factory…