The Federal Reserve raised its benchmark interest rate by 25 basis points last Wednesday, launching into what is expected to be a more rapid series of increases that is intended to ward off inflation but will also raise costs for Americans who borrow money to finance mortgages, auto loans and credit card purchases.
Fed officials voted to raise the central bank’s key interest rate for overnight lending by a quarter point, from a range of 0.5pc to 0.75pc to a range of 0.75pc to 1.0pc. Bank officials announced the decision last Wednesday afternoon following a two-day policy meeting in Washington.
The Fed has long planned on raising interest rates to a more normal level, after slashing them to nearly zero during the financial crisis and holding them at an ultra-low level for years to stimulate a sluggish economy. After some tentative steps, the last Wednesday hike signals a significant transition
“This is a sea change for them, to start talk about raising rates at a faster pace,” said Blu Putnam, CME Group’s chief economist.
The Fed’s decision could also frustrate the ambitious goals of the Trump administration, including boosting growth rates to a pace not seen in years and reviving manufacturing and exports. By raising the cost of borrowing, higher interest rates tend to dampen growth. They also attract investment to the United States, which pushes up the value of the dollar and makes US exports comparatively expensive abroad.
Investors were well-prepared for the move, as Fed officials have made numerous speeches telegraphing their decision in recent weeks. Before last Wednesday’s announcement, futures markets pointed to a 95pc probability of the rate hike.
By raising the cost of borrowing, higher interest rates could dampen the economy’s growth — and also likely attract global investment
The Fed carried out its first rate increase since the global financial crisis in December 2015, and another in December 2016. But the uncertainty surrounding the US presidential election and persistent threats to global growth, such as a stock market crash in China last year, persuaded the Fed to otherwise hold off.
“It feels like we are at a transition to somewhat more regular increases,” said Michael Feroli, chief US economist at J. P. Morgan. In the past, the Fed “just didn’t get the global headroom” to be able to raise rates, he said. “I think for now the coast looks clear.”
The Fed has long insisted that it will match the pace of its interest rate hikes to the progress of the economy. And in recent months, the US economy has finally showed signs of heating up. While gross domestic product, a broad measure of economic growth, remains disappointing low, the unemployment rate has fallen below the Fed’s long-term projections, companies continue to add hundreds of thousands of jobs per month, and there are signs that a long-absent increase in inflation could be just around the corner.
Given these more encouraging signs, the Fed is eager to move interest rates away from what economists call the zero-lower bound — meaning interest rates hovering around zero per cent. That would give the Fed room to cut rates to stimulate the economy, in the event of economic troubles in the future.
Some argue that, by raising rates too quickly, the Fed risks choking off progress for the poorest Americans, just as they dig themselves out of the recession. But others say that, by delaying, the Fed risks inflating asset bubbles in the market or letting inflation get out of hand — something market watchers term ‘falling behind the curve.’
“The Fed still has their foot on the monetary accelerator almost to the floorboard. They have to take that foot off,” said Steven Rick, chief economist at CUNA Mutual Group. “We’re concerned that maybe they are behind the curve.”
“The economy can absorb these rate hikes, and it’s past time we got on with it,” said Joe Brusuelas, chief economist at RSM US.
Market watchers were also keeping a close eye during last Wednesday’s meeting on the massive balance sheet that the Fed accumulated during the financial crisis. To boost lending in the economy, the Fed bought massive amounts of Treasuries, mortgage-backed securities and other assets during the financial crisis, expanding its balance sheet from less than $900bn to roughly $4.5tr today.
The Fed has tapered off purchases of these assets, but it has not yet started reducing the size of the massive balance sheet.
The Fed argued that these extraordinary measures were needed to keep the United States out of another Great Depression. But some have criticised the move as exceeding the Fed’s congressional mandate, and say that it distorts the market by holding down longer-run interest rates.
The policies of the new administration are clouding the outlook for the Fed. Trump came into office with sweeping plans for the economy, including slashing corporate taxes, cutting regulations and boosting spending on infrastructure. If these policies materialise, they are likely to boost economic growth and spur inflation, potentially forcing the Fed to hike rates more quickly to keep up.
By raising the cost of borrowing, higher interest rates could dampen the economy’s growth — and also likely attract global investment, which will push up the dollar and weigh on US exports.
The Washington Post Service
Published in Dawn, Economic & Business, March 20th, 2017