Update, Dec. 16, 2:20 p.m. Annnnnnd we have liftoff. As anticipated, the Federal Reserve announced today that it would raise its target for short-term interest rates by a quarter of a percentage point. Original post below:
The big announcement is almost here, people. On Wednesday, the Federal Reserve is expected to finally raise interest rates up from near zero, where they’ve sat since the financial crisis seven years ago. The hike will likely be quite modest, the beginning of a long, slow, and probably somewhat tedious process meant to head off the possibility of inflation in the future without tanking the economy in the present. Still, this marks the final curtain on an era—the era of the zero-interest rate policy, or if you prefer acronyms that sound like the name of a cartoon alien, ZIRP.
Why should you care? Is getting a mortgage going to be much more expensive? Is Fed Chair Janet Yellen about to lay waste to the economy and steal your raise? Is this really more important than reading up on the fine points of Star Wars cosmology? Here’s what you need to know.
What exactly is the Fed up to?
Think of Wednesday’s decision as the most hotly anticipated baby step in the annals of monetary policy. The Fed dropped interest rates to zero during the depths of Wall Street’s meltdown in December 2008, then left them there to help the economy heal from the recession. Now, after the better part of a decade, Yellen and her colleagues finally believe the U.S. is healthy enough that they can start bringing rates back to normal levels in order to prevent inflation from rising too much down the line.
But Yellen wants to be slow and careful about it. The Fed will likely raise the target for its benchmark interest rate by just a quarter of a percentage point. After that, assuming we don’t end up in another downturn, policymakers have suggested that they plan to raise rates, gradually, so that they might top 3 percent or so around 2018—still quite low by the standards of the past 50 years. If things go awry—say, growth starts looking shaky—they can slow down further. Again, we’re talking baby steps. Adorable, macroeconomic baby steps.
What does this mean for me?
When the Fed raises short-term interest rates, it indirectly increases the cost of borrowing across the entire economy. So, over time, it should get more expensive for Americans to get a mortgage or businesses to take out loans for new equipment. As a result, companies and families tend to borrow less. That slows down growth, meaning fewer new jobs and smaller raises for workers.
But why would anybody want to slow down the economy?
Inflation, my friend, inflation. The Fed is charged with two main responsibilities, often referred to as its “dual mandate.” By law, it’s supposed to promote maximum employment while also keeping prices stable. That means making sure the economy doesn’t get too overheated. Otherwise, prices will start shooting up.
How come? When the economy is firing on all cylinders, there will theoretically come a point where just about every worker who wants a job will have one, which will force businesses to start offering better pay in order to hire or keep employees. As wages rise and workers have more to spend, companies can then charge them more for groceries and cars and those horrible scooters children ride around on. Voilà, inflation. (Side note: Even if employment isn’t maxed out, overly loose monetary policy can still drive inflation, but at the moment, it seems like the Fed is mostly worried about a tightening labor market.)
The economy still kind of sucks, though. Why would anybody worry about it overheating?
Well, that sort of depends on how you look at things.
On the one hand, yeah, in some ways the economy still feels like a big bowl of lukewarm gruel right now. The headline unemployment rate (in red below) is down to 5 percent, which is decent. But once you start considering the number of Americans who are working part-time for lack of a better option or who are out of work, want a job, but just haven’t looked recently (see the U-6 rate, in blue below), the labor market still looks a bit tepid. Also: Labor-force participation is at lows we haven’t witnessed since women were still just joining the workplace.
As for inflation, as Matt Yglesias noted earlier in his delightful screed about Fed tightening, it’s been nearly nonexistent. The central bank targets a 2 percent rate. And due to the magic of low oil prices (thanks, Saudi Arabia!), the Fed’s preferred inflation measure is up just 0.2 percent through October. Once you subtract food and energy from the picture, you get to 1.3 percent.
So, if inflation is all but invisible and the job market still has a ways to go before full employment, why would anybody in their right mind try to raise interest rates?
Yes. Please explain.
The Fed isn’t really worried about inflation tomorrow. Rather, policymakers are trying to head it off a year or two down the line, when the economy may be a bit stronger. And because changes in monetary policy can take months or even years to have an effect as businesses and households adjust, the central bankers think it’s probably prudent to start now so they don’t have to take drastic measures that could shock the economy into a recession later. Here’s how Janet Yellen explained it in a speech earlier this month during which she set the stage for “liftoff,” as everybody has taken to calling this first hike:
We must also take into account the well-documented lags in the effects of monetary policy. Were the FOMC to delay the start of policy normalization for too long, we would likely end up having to tighten policy relatively abruptly to keep the economy from significantly overshooting both of our goals. Such an abrupt tightening would risk disrupting financial markets and perhaps even inadvertently push the economy into recession. Moreover, holding the federal funds rate at its current level for too long could also encourage excessive risk-taking and thus undermine financial stability.
That last bit about financial stability feels especially pertinent this week, after the recent sell-off in the junk bond market. Because the Fed has kept interest rates low for so long, investors desperate to get a return on their money have piled into fairly speculative assets like debt from janky companies with low credit ratings. Lately, many of those investments have been going south. And while the carnage hasn’t spread much beyond some bond funds, it’s a reminder that when borrowing is cheap and returns are hard to come by, Wall Streeters will take on a lot of risk.
Meanwhile, if you look closely enough, it’s not totally insane to think that, in a year or two, inflation could start to pick up. Wage growth hasn’t been scintillating, but it’s been headed higher lately. Federal Reserve Bank of Atlanta President Dennis Lockhart, who is known to have pretty moderate views, points to a measure known as the trimmed mean PCE, which is basically designed to be less erratic than other inflation measures. It shows prices rising at a 1.7 percent annual rate over the six months through October. You have to squint a bit to see the evidence, but there is some.
Beyond that, it’s not clear our monetary policymakers think the first rate hike or two will really do much to the economy at all. During a recent speech, Lockhart said he didn’t think “a first move of 25 basis points will have a material effect” on the economy’s strength. Both Lockhart and Yellen have suggested that the labor market should continue to improve after a hike. The logic seems to be, why wait?
So there’s nothing to worry about?
I mean, it’s hard to say. The Fed has been telegraphing its intention to raise rates for so long that markets may have already priced it in, in which case this first move might in fact mean squat. Perhaps the long and slow approach to normalizing rates will keep the economy from suffering any adverse consequences, or give the Fed a chance to back off if things look like they aren’t going according to plan. Or, maybe Yellen & co. really are jumping the gun and tightening before the economy has had a chance to fully recuperate, thus cutting off our chance of ever hitting full employment in the near future. Internet headlines aside, nobody ever really has the answers to those questions. And none of that even touches the big and involved issue of whether the Fed should maybe be willing to tolerate inflation above its 2 percent target in the future for the sake of job and wage growth now.
But anyway, say goodbye to ZIRP. Such a delightful little phrase.