The Federal Funds Rate Hike
The New York Times, in an article by Binyamin Appelbaum entitled "Fed raises key interest rate for first time in almost a decade" discussed the pronouncement of the Federal Open Market Committee ﴾FOMC﴿ to increase the Federal Funds rate. The decision came exactly seven years after the financial crisis in 2008 when the FOMC reduced its rates to near‐ zero level to prevent the economy from collapsing. The article described the move as signaling the beginning of the end of the Fed 's stimulus program and highlighted the Fed statement that the Fed intends to increase the rates gradually and only if the economic growth continues. The Fed rate would range from 1/4 to 1/2 percent, possibly increasing the short-term rates by one percentage point a year for the next three years. The article pointed out that the Fed emphasized that "there has been considerable improvement in the labor market conditions this year and it is reasonably confident that inflation will rise over the medium‐term to its 2 percent objective". Further, the Fed projected an economic expansion by 2.4 percent and a drop in unemployment rate to 4.7 percent which the Fed deemed as most healthy indicators. FOMC chairwoman Janet L.Yellen was mentioned as saying that the Fed is raising its rates despite the sluggishness of inflation as inflation is temporarily being suppressed by factors like lower oil prices but would rise to the 2 percent inflation target as job growth continues. She underscored that the Fed needs to act now because monetary policy works gradually.
The article acknowledged the Fed move but opined that if the Fed moves too quickly, it risks undermining the current economic recovery. The sentiment is shared by some economists, the Democrats and even some Fed officials who earlier argued that the economy is not yet ready. The decision is regarded as too risky and that it would curtail job and wage growth and adversely affect the middle class as well. There is also the apprehension that every developed nation raising interest rates since the end of the financial crisis has been forced to backtrack as growth slowed.
The article also raised varied reactions to the Fed move pointing out that the financial markets showed mild initial reactions with the Standard & Poor’s stock index still on the rise. JP Morgan, Wells Fargo and the Bank of America tend to take advantage of the benefits of the Fed rate hike by increasing profit margins instead of passing the benefits to the depositors. Some analysts believe that the Fed rate increase would raise mortgage rates as well as other long-term loans although not automatically. Economic activities such as in the car industry may also be curtailed by high borrowing rates. In the financial market, there is stress amongst financial firms to adjust as the Fed requires them not to lend below the new rates.
Role of the Fed. On the whole, much of the analysis of this article would entail looking into the rationale behind the Fed rate hike and the impact of such decision on various economic variables. To start with, it is essential to dwell on the role of the Federal Reserve or the Fed. As a central bank, the Fed conducts monetary policy to promote the objectives of maximum employment, stable prices and moderate long-term interest rate. One of the monetary tools employed by the FOMC –the policymaking body of the Fed is the Federal Funds rate – the interest rate which banks charge each other for overnight loans of reserve balances. The FOMC sets the Fed funds rate at a level it believes is consistent with achieving its monetary policy objectives and it adjusts its target in line with evolving economic developments. ( Monetary policy n.d.). Thus, the Fed keeps interest low to boost economic activity and increase money supply and credit as an expansionary or accommodative monetary tool. In turn, the Fed adopts a contractionary or tightening monetary policy when it raises the federal funds rate in order to restrain inflation and to regulate economic growth. A change in the federal funds rate can trigger chain reactions that will influence other short-term rates, longer-term interest rates, the foreign exchange value of the dollar and stock prices. In turn, changes in these variables will affect total amount of money and credit as well as spending and investment patterns, and ultimately, employment, output and inflation.
In analyzing the recent move of the FOMC to raise the Fed rate, it is useful to understand some of the economic variables affected by monetary policy and how they are influenced by the Fed rate hike.
Effects on the Lending Market. As the Fed rate increases, the banks are expected to pass on higher interest rates on consumer loans, credit cards, car loans thereby increasing borrowing costs for firms and households. Changes in short-term loans may also influence long-term interest rates such residential mortgage rates. Changes in financial conditions affect spending patterns of households and firms. For example, when short-term and long-term interest rates go up , it becomes more costly to borrow, so households are less willing to buy goods and services and firms are constrained not to buy more goods e.g. property and equipment to expand their businesses.
Effects on Investment. Investments are made on assets or items purchased in the hope that it will generate income or will appreciate its market value over time. These are usually made on long- term basis such as when people put in their funds in projects or businesses designed to make profit in due time. Buying and keeping jewelries, land, and works of arts are other forms of investing people resort to promote the goal of value appreciation. Investing is commonly done through intermediaries such us pension funds, banks, brokers and insurance (Investment n.d.). Investments create jobs and enable the employed and their families to buy. In the process, the other businesses are fueled. It facilitates exports; and technology enhancement; and productivity. Investments strengthen the manufacturing and services sectors. Overall, higher rate of interest favors the investments done through those intermediaries since the return for the funds that they are holding for re‐ lending will be higher, assuming there are takers of high cost of mortgage and loans. The case of shares of stocks at the stock markets differs in some fine points due to the characteristics of the stock market (Mueller J. 2015). The stock market is the aggregation of buyers and sellers of stocks also know as "shares". The securities in stock market is either listed publicly or traded privately in the so‐called Over-the-Counter ﴾OTC﴿ set-up. The stock market operates or do business in stock exchanges ‐ the physical venue where sellers and buyers meet and transact. The stock market facilitates the raising of money by companies by trading their shares. Currently, companies are enjoined to open up to the public through the Initial Public Offering ﴾IPO﴿. The New York Stock Exchange ﴾NYSE﴿ is one of the world's leading thoroughly watched and monitored as it sets the pace in stock trading . Stocks may be listed in several stock exchanges in various countries. The advent of computer/Internet gave rise to virtual stocks trading exemplified by NASDAG. The intensity or passiveness of stock trading is popularly known as “bullish” or “bearish”, respectively. The stock market is sensitive to the domestic and global events and developments in business, economic, political and social dimension. The recent Fed action tends to “rein” the economic upturn in the US in order to avoid overheating, inflation and price increase. With its action, the cost of borrowing will increase and stifle some business' expansion. It may similarly impinge on profitability. These foreseen effects may discourage players in the stock market to withhold their placement and buying of stocks of companies affected by the Fed move. Instead, they may turn to more secured securities like government bonds and similar instruments. Other companies expecting greater revenue growth are not at all affected by the rate increase and are shielded. Their stocks’ marketability remains strong. Thus, the negative effects of the Fed rate increase do not apply to the entirety of the stock market (Shoupe S. and Sunny, G. 2013).
Effects on Employment. The Bureau of Labor Statistics (BLS) of the Department of Labor of the US defines people with jobs as "employed". Those who are jobless, looking for a job, and available for work are "unemployed". Both constitute the "labor force". Every year those who turn 16 years old join the labor force as “new entrants”. Since the labor force is a moving number, additional jobs may increase but negated by the new entrants. Thus, unemployment is considered as the determining factor on the situation of the economy. The BLS reported that unemployment rose from a yearly average of 4.9% in 2005 to 7.3% in 2008. In spite of the zero-rate (0%) adopted in 2008 by the FED, unemployment jumped to a high of yearly average of 9.9% in 2009. As the economy improved, it came down to 5.0% in 2015. This is indicative that jobs have been adequately generated when business and industry in the country have been stimulated by cheaper loans and working capital.
The impact of the FED action on unemployment is highly significant. It will bring about displacement to those with jobs when their companies find the cost of new money for operation or expansion expensive and anathema to viability. Once unemployed, the workers and their families will lose wages and income while the economy will have less products and services. With lost purchasing power, the market for the goods and services of the unemployed will be diminished and will negatively impact on those producing them. The ripple effect of the unemployment of those directly affected may spread to other sectors of the economy. The total economy will suffer in the process.
Effects on the Economy. One of the primary indicators used to gauge the health of the economy is the Gross Domestic Product or GDP. It represents the total value of all goods and services produced over a specific period of time. It can be calculated through either the income approach or the expenditure approach. The income approach measures the incomes earned by the factors of production i.e. wages for labor; profits for capital, rent for land from all sectors of the economy. On the other hand, the expenditure approach calculates aggregate demand by adding up consumption, investment, government spending and net exports. Real GDP is considered a better measure of the economy since it is adjusted for inflation. The latest GDP estimate for the US is 2.0 percent for the third quarter of 2015. Given that the Fed rate hike affects the components of GDP i.e. consumer spending, investment, employment and production, there is that apprehension that the Fed move may have adverse effects on the US economy. However, the linkages from monetary policy to production and employment do not immediately materialize and are influenced by a range of other factors, which makes it difficult to gauge precisely the effect of monetary policy on the economy.
Effects on Inflation. When the Fed rate is raised, consumers tend to have less money to spend. With less spending, the economy slows and inflation decreases. Inflation is the sustained increase in the general price level of goods and services in an economy over a period of time. The CPI is used to calculate inflation. The Bureau of Labor Statistics of the US Department of Labor defines CPI as “a measure of the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services. The latest inflation rate for the United States is 0.7% through the 12 months ended December 2015 as published by the US government on January 20, 2016 (Inflation Calculator, 2016). As it stands, it would seem that inflation has continued to run below the 2% percent longer-run objective set by the Fed.
Effects on the Emerging Markets. The Fed rate hike will not only impact on the US economy. Considering the unique role of the dollar as the world’s reserve currency, Fed decisions have consequences for the global economy. Changes in the federal funds rate will always affect the US dollar. An increase in the Fed rate works to appreciate the dollar. This becomes a serious concern for some emerging economies that have binged on cheap dollar debt to finance their large scale projects or consumption (Global economy watch, 2015). The vulnerability of emerging markets with regards to their holdings of dollar-based debt is a serious concern .
Evaluation and Conclusion
The relationship and linkages of the Fed rate hike with the economic variables would seem to reflect what to expect from the recent Fed’s monetary stance. The article acknowledged the Fed move but is indeed correct in cautioning the Fed regarding the pace of the implementation of the Fed rate increases.
A key issue in the Fed rate action is the need to assess the prevailing economic conditions and outlook. The FOMC pledged that its moves will be gradual and only if the economy improves. In determining the timing and size of the adjustments in the Fed rate, the FOMC must assess realized and expected economic environment extensively. The FOMC must closely monitor the labor market conditions, the indicators of price pressures including the decline in energy and non-energy, financial market and investor reactions and international developments. Thus, the actual path of Fed rates movements should be based on accurate regular evaluation of economic variables that would affect domestic as well as the global economy. In particular, future Fed action should be guided by economic outlook on job and wage growth and stable prices, among others.
Another important concern in planning the direction of future Fed rate movements is the availability of up-to-date information on the state of the economy and prices. Useful information is limited by lags in the construction and availability of data and by further revisions of estimates which can greatly change the situation. Given this constraint in assessing realized impact of monetary policy, right timing of the implementation of the Fed actions is significant.
With regards to the apprehension that the Fed rate hike could lead to an economic slowdown, the Fed assured that the policy remains accommodative and that the Fed does not desire to curb consumers from spending and businesses from investing. The Fed stressed that the interest remained low even after the rate hike, near levels economists regard as appropriate for a recession. (Schneider H. and Lange J. 2015 ). Further, to support this contention, the FOMC announced that it is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities and of rolling over maturing Treasury securities at auction. It intends to do so until the normalization of the level of the federal funds rate is well under way. This policy of keeping the FOMC’s holdings of longer-term securities at sizable levels, should help keep maintain accommodative financial conditions (Press release 2015).
Movements in the Fed rate do not affect the US economy alone. In this light, the monetary tightening mode of the Fed must consider the adverse impact on the emerging markets that borrow in dollars. According to the IMF, higher US rates combined with the easing in the euro zone and Japan, could push up the dollar, making life harder for the many companies in emerging economies that borrow in dollars. For emerging economies, this could raise vulnerabilities in sectors with dollar exposures, especially corporate. The Fed must heed the advice of the IMF regarding the negative implications for the emerging economies (Thomas L. and Schomberg W. 2015).
Further, the limitations of the monetary policy should be considered in light of the fact that the economic variables affected by the fed rate hike are also influenced by many other factors. Monetary policy is not the only factor that acts on output, employment and prices. The government may influence the economy through changes in taxes and spending programs. For instance, an increase in tax rate may influence the economy as this move may curtail consumption, thereby affecting aggregate demand. Other factors affecting aggregate demand are changes in consumer and business confidence as well as changes in the lending postures of commercial banks and other creditors. On the other hand, the supply side of the economy may also be affected by disruptions in the oil market, agricultural losses, natural disasters (Monetary policy n.d.)
In sum, the recent Fed rate hike is conceived as a monetary policy stance of the US central bank to achieve maximum employment, stable prices and moderate long-term interest. The move, though seen as contractionary is still regarded as accommodative by the FOMC since the rates remain low even after the Fed rate hike. The FOMC action is also coupled with its policy of keeping the FOMC’s holdings of longer-term securities at sizable levels, to keep maintain accommodative financial conditions. The main concern still is how to determine the right timing and size of the Fed rate increase. To do this, the FOMC is faced with the challenge of assessing realized and expected economic indicators that would indicate the direction that the Fed rate should take. Limitations as to time lag and availability of data need to be addressed. The FOMC is further challenged to consider the negative effects of the Fed rate movements on emerging economies. And, finally expectations from the effectiveness of the Fed rate movements to achieve desired economic objectives may be weighed down by the limitations of monetary policy in view of other factors that affect the economy.
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