The Federal Reserve Announces Interest Rate Increase

The Federal Reserve announced today that it will raise the federal funds rate .25 percent to a range between 1.75 percent and 2 percent. This is the seventh time the Fed has raised short-term interest rates since December 2015 and the second time this year. The Fed’s projections point towards two more rate increases this year, bringing the total to four quarter-point rate increases in 2018. This is higher than initial estimates of three rate increases, and largely due to the Fed seeing a strengthening labor market and “solid” economic activity.

Background:

The federal funds rate is the rate at which depository institutions make overnight loans to one another and is used as a baseline for other borrowing rates. The Fed sets a target range for the rate and then conducts open market operations in order to achieve the target. When the Fed wants to increase the federal funds rate, it sells government securities – which decreases their price and increases the rate (bond prices and rates move inversely); when the Fed wants to lower the rate, it buys government securities. In this way, the Fed has broad power over monetary policy and uses the federal funds rate as its primary policy tool.

During the financial crisis, the Federal Reserve dropped the federal funds rate to near-zero and kept it there until December 2015. They did this in order to encourage investment and get the economy going. However, due to the severity of the economic damage, the rate remained near-zero for roughly seven years. In addition, the Fed took extraordinary steps to support the economy by buying very large amounts of longer-term government securities and mortgage-backed securities. These actions helped to drive down the cost of long-term borrowing, but it also added trillions of dollars to the Fed’s balance sheet. Now that the economy has improved, the Fed is wanting to return to a more “normal” policy environment, by slowly increasing interest rates and reducing their balance sheet.

Current Conditions:

With a solid labor market and steady economic growth, the Federal Reserve is trying to reign-in inflationary pressures, while at the same time keeping the current economic expansion going. The US is currently in the midst of the second-longest economic expansion on record at 9 years; and has experienced a growing pace of hiring and a decline in the unemployment rate.

For much of 2017, the story was of a wage-less expansion. Even while the labor market was tightening, and employers were having an increasingly difficult time finding workers, wage growth struggled to improve. However, over the last couple of months there has been an increase in annual wage growth and in other inflation indicators. This has given the Fed the confidence to increase their rate hike path to four quarter-point increases this year; up from an initial projection of three.

Future Risks:

The Fed is in a precarious position and the new Fed Chairman, Jerome “Jay” Powell, will need to make some difficult decisions. The unemployment rate fell to 3.8 percent in May and is well-below what many would consider to be full employment. While this is good for workers, it can sometimes lead to wage-induced inflation, as employers are forced to compete for qualified labor by increasing wages. If the Fed thinks wage inflation is around the corner, they may need to raise rates faster than anticipated. However, the decline in the labor force participation rate – which measures those working and looking for work – points to slack in the labor market. If slightly higher wages could pull more people off the sidelines and back into the labor force, then the Fed can be more measured in their rate increases. But, if the Fed gets the timing wrong and raises rates too aggressively, they risk keeping these potential workers on the sidelines and out of the workforce. 

Another factor that complicates the Fed’s future policy path is the recently passed tax reform. While the tax plan is projected to add to economic growth, its simulative effects could be coming at the wrong time. The economy is already past full employment and inflation is beginning to pick up. The growth brought on by tax reform could force the Fed to increase rates faster than anticipated. If this were to happen the Fed risks pushing the economy into recession.

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