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Interest Rate Debate Hinges on 3 Factors

The U.S. Federal Reserve decided against raising the federal funds rate at its latest meeting in September, extending its zero interest rate policy and ramping up the debate about what it will take for the Fed to act. Disagreements in 3 areas explain the Fed’s caution.

  1. The most crucial and most recent influence on the Fed has been global economic and market weakness. In a press conference announcing the “no” decision, Fed Chair Janet Yellen said the Federal Open Market Committee (FOMC) needed more time to “evaluate the likely impact” of slowing growth and declines in the Chinese and other global equity markets before commencing a rate tightening cycle. The leader of the International Monetary Fund, which plays a role similar to the Fed for the global economy, has also urged the Fed to take a cautious approach to raising rates. While these concerns are valid, consumer spending drives about 70% of the U.S. economy and weaker overseas markets will only act to make goods cheaper, which should be a boon to spending. In addition, second-quarter U.S. GDP growth was recently revised higher to 3.9%, indicating that the domestic economy continues to expand. FOMC member Jeffrey Lacker agrees with this assessment and cast the lone vote to raise rates in this month’s meeting.[1]
  2. Debate over the strength of the jobs market is also giving the Fed pause. The unemployment rate has dipped to 5.1%, its lowest level in seven years, but that number doesn’t tell the whole story. Fewer Americans are in the workforce today than in past recoveries—as judged by a stat called the labor market participation rate[2]—and a version of the unemployment rate that takes into account the number of individuals working part-time due to lack of full-time work is still above 10%, suggesting that substantial slack still remains in the labor market. This is important because employers are not yet facing strong pressure to raise wages to hire new workers or keep existing ones. Until this happens, inflation should remain in check.
  3. Policymakers and pundits are also divided over the risks of persistently low inflation. A sharp drop in commodity prices over the last 15 months has kept inflation well below the 2.0% annual rate that the Fed considers price stability. With a lack of price pressure, some Fed followers suggest that Yellen & Co. are willing to let the unemployment rate fall below 5% and allow the U.S. economy to run hot for a period before beginning to tighten monetary policy.[3] But another camp, led by MIT economist Athanosios Orphanides, warns that the Fed is too late and should have begun raising rates long before the economy reaches full employment.[4] Orphanides is worried that the Fed will be forced to act aggressively should inflation spike, a move that could usher in recession. Yellen acknowledged those inflation risks in a September 24 speech in which she asserted that the Fed will raise rates by the end of the year.

These are unusual times for the Fed as the degree of accommodation since the global financial crisis has been unprecedented. Should the economy run into another rough patch with rates near zero, they will have few remedies left to stimulate growth. But if rates were to rise gradually, the Fed would win back the ability to lower rates again to ward off trouble.

[1] Marketwatch. “Fed’s Lacker Defends Lone Vote For Interest-Rate Increase.” September 19, 2015

[2] Market Realist. “Solid Job Additions and Slack in the US Labor Market.” September 20, 2015

[3] Wall Street Journal. “Memo to Fed: Let the Economy Overheat.” June 17, 2015

[4] CNBC. “Fed blowing its chance to raise rates: Economist.” September 24, 2015

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