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Why Is the Fed Raising Rates? Better to Ask, Why Not? Fed Raises Interest Rates for Third Time Since Financial Crisis
(about 9 hours later)
The Federal Reserve on Wednesday is expected to raise its benchmark interest rate for the third time since the financial crisis. The Fed is expected to announce the decision at the conclusion of a two-day meeting of its policy-making committee. The move comes earlier than markets anticipated at the beginning of the year. The Federal Reserve delivered the widely expected increase in its benchmark interest rate on Wednesday, and said the domestic economy remained on a path of slow and steady growth.
Why is the Federal Reserve raising interest rates? The decision raises the Fed’s benchmark rate to a range between 0.75 percent and 1 percent.
It’s illuminating to flip the question on its head: Why not? In a statement after a two-day meeting of its policy-making committee, the Fed said that the United States economy continued to chug along, expanding at a “moderate pace.” Employers are hiring, consumers are spending and businesses — the laggards in recent months — are starting to spend a little more, too.
The unemployment rate, one of the gauges the Fed watches most closely, fell to 4.7 percent in February, a healthy level by historical standards. Inflation, the other gauge, finally appears to be reviving. Prices rose 1.9 percent over the 12 months ending in January, close to the Fed’s 2 percent annual target. The Fed also highlighted a recent increase in inflation after a long period of sluggishness. Prices are now rising at roughly the 2 percent annual pace that the Fed regards as optimal. The Fed, which had made faster inflation a central objective, said on Wednesday that it was now focused on stabilizing inflation.
The Fed continues to hold its benchmark interest rate at a level intended to stimulate economic growth by encouraging borrowing and taking risks. It sits in a range from 0.5 percent to 0.75 percent. It is the first time in recent years that the Fed’s forecasts have moved in the direction of tightening, a change in tune that parallels the Fed’s confident tone and its decision to raise rates on Wednesday.
The Fed’s goals are getting closer. Officials want to ease up on the gas. There was one dissent. Neel Kashkari, president of the Federal Reserve Bank of Minneapolis, voted against raising interest rates. The Fed’s statement did not provide a reason for Mr. Kashkari’s vote.
But the economy is still growing at a lackluster pace. The Fed’s assessment of economic conditions remained quite measured. There was no sign of the ebullient optimism President Trump had shown in recent comments about the economy.
That’s true. The government estimates that the economy grew just 1.6 percent in 2016, compared with 2.6 percent in 2015. Moreover, private economic forecasters don’t see signs of an acceleration in the first quarter of 2017. A new round of economic projections from the Fed’s senior officials was nearly unchanged from the last round of projections in December. The Fed continues to forecast a Goldilocks economy, with the unemployment rate remaining at 4.5 percent and inflation around 2 percent for the next three years.
But the most important factor is the slow pace of productivity growth. An increased number of Fed officials are expecting to raise rates at least twice more this year. Only three of the 17 officials who submitted forecasts now expect the central bank to move more slowly. There was a similar coalescing around tighter policy for the following two years, although the median prediction of a 3 percent funds rate by the end of 2019 remained unchanged.
There are only two ways to expand an economy: add workers, or get more out of every worker. The domestic work force is growing slowly, and lately, so is productivity. Low interest rates can’t fix either problem. The rate hike will increase the upward pressure on interest rates that consumers pay, but the immediate effect is likely to be modest. People with credit card debt are likely to see an immediate increase of about a quarter percentage point in their interest rates. The effect on longer-term loans is less direct, but the average rate on a 30-year mortgage rose by half a percentage point over the last year.
The Fed’s chairwoman, Janet L. Yellen, has urged the rest of the government to consider policies that might increase productivity growth, like investment in education or infrastructure, or changes in government regulation. But if anything like that happens, it won’t be for a long time. The nation’s largest borrower, the federal government, will also feel the pinch of higher rates. Federal interest payments, measured as a share of the economy, are expected to double over the next decade, according to the Congressional Budget Office.
For now, the Fed has concluded that the economy is growing at roughly the maximum sustainable pace. In this view, stimulating faster growth by keeping interest rates at a low level would simply drive up inflation. Savers are unlikely to benefit immediately. Banks tend to raise interest rates on loans more quickly than they raise rates on deposits. That was certainly the pattern after the Fed last raised rates, in December. Last week, the average rate on a six-month certificate of deposit was 0.14 percent. Last year at this time: 0.13 percent.
Wait, you mentioned workers. Millions of American adults are not working. Couldn’t low interest rates help to create more jobs? Wednesday’s decision quickens the Fed’s march toward higher rates. The Fed raised rates for the first time since the financial crisis in December 2015. It waited a full year before the second hike. The third comes just three months later.
One of the most worrying economic trends in American life is the long-term decline in the share of prime-age adults who are working. Last month, 21.7 percent of men and women ages 25 to 54 did not work. One reason for that is that economic growth remains slow. The economy expanded by just 1.6 percent in 2016, and there is little sign of an acceleration during the first quarter. But the Fed has concluded that the economy is growing at something close to its maximum sustainable pace.
Most of those people, moreover, are not counted in the unemployment rate because that government statistic counts only people who are actively seeking employment. The Fed, charged with maximizing employment and moderating inflation, is close to achieving both goals. The unemployment rate fell to 4.7 percent in February, a level consistent with the normal churn of people moving among jobs.
Faster economic growth could help to draw people back into the labor force by encouraging employers to offer higher wages or to invest in training. This happened on a large scale in the 1990s, and some economists want the Fed to try it again. Inflation is finally starting a comeback, and moderate as it is, that’s not a bad thing. The Fed’s preferred measure rose 1.9 percent over the 12 months ending in January, close to the Fed’s 2 percent annual target.
Others, however, are dubious that lower rates can expand the work force much further. They point to evidence that many of those not working have health problems, educational deficits or other issues that make them less attractive to employers. The Fed’s policy-making committee next meets on May 2 and 3.
The Fed isn’t giving up just yet. The expected rate increase on Wednesday would leave the benchmark rate below 1 percent. That is still a level intended to provide a modest stimulus.
O.K., the Fed is raising rates on Wednesday. What happens next?
The Fed said in December that it planned to raise rates three times in 2017. This would be the first increase. If the Fed kept to that schedule, its benchmark rate would end the year in a range from 1.25 percent to 1.5 percent.
The Fed is also scheduled to publish a new round of forecasts by its top officials on Wednesday. Analysts and investors will be looking closely for signs that the Fed is thinking about adding a fourth rate increase this year or moving faster in coming years.
More rate increases would suggest that the Fed thinks the economy will continue to get better. Since the financial crisis, almost every change in the Fed’s forecasts has been in the direction of greater pessimism. Optimism would be a new look for the central bank.
Is the Fed trying to pop a bubble in the stock market?
Fed officials have been measured in their comments about the market’s rapid rise. William C. Dudley, the president of the Federal Reserve Bank of New York, said last month that since the presidential election, “animal spirits have been unleashed a bit.” Ms. Yellen offered a similar analysis in congressional testimony last month. “I think market participants likely are anticipating shifts in fiscal policy that will stimulate growth and perhaps raise earnings,” she said.
Officials have cited the market’s rise as one reason for moving toward higher rates. Among other things, higher stock prices mean investors have more money to spend. But there is no sign of a determined effort to pop a bubble.
Should consumers rush to buy houses or cars before rates start rising?
When the Fed raises interest rates, consumer borrowing costs tend to increase, but the relationship is not mechanical. The average interest rate on new car loans, for example, was 5 percent in 2015 and 4.9 percent in 2016, even though the Fed raised its benchmark rate for the first time since the financial crisis at the end of 2015.
The basic reason is that loan rates reflect other factors, including expectations about future financial conditions. In general, the longer the term of the loan, the smaller the impact of the Fed’s decision making. Rates on credit card debt tend to increase immediately; the impact on mortgage loans is more difficult to predict.
Over the longer term, however, the Fed’s gradual march toward higher interest rates is likely to raise borrowing costs for pretty much every kind of loan.
Will savings accounts finally start to pay a rate that is not so laughably low?
Probably not any time soon. Banks tend to raise interest rates on loans more quickly than they raise rates on deposits. That was certainly the pattern after the Fed last raised rates, in December. Last week, the average rate on a six-month certificate of deposit was 0.14 percent. Last year at this time: 0.13 percent.