The Federal Open Markets Committee (FOMC) voted to raise short-term interest rates by a quarter-point at this week’s meeting, taking another small step on the long path toward normalization. Rates have been extraordinarily low since the 2008 financial crisis, but the economy finally seems strong enough to support higher borrowing costs.
With interest rate normalization fully underway, I’ve found myself answering a number of common questions about the effects this may have on the broader economy—hopefully these six FAQs will help you better understand this changing environment.
Markets were prepared for this week’s rate hike. A February jobs report that was stronger than expected set the stage for the Fed’s action, and futures markets have been pricing in an almost certain hike for several weeks. Rising rates are unlikely to provoke an abrupt reaction from investors, whose expectations are already aligned with the Fed’s normalization plans.
The Fed lowered interest rates to near zero during the recession; as the economy returns to full strength, rates have to normalize in order to contain inflation. During the recession, demand for capital was low, as relatively few businesses needed to finance new expansions. In response, the Fed lowered the price of borrowing to encourage capital investment. Now that demand from the private sector is picking back up, borrowing costs will need to rise as well.
Unemployment has fallen to 4.7 percent, and job creation continues to surpass population growth, putting the labor market on a trajectory toward full employment. While inflation has yet to surpass the Fed’s official 2 percent target, the FOMC is hoping that a gradual normalization process can control price pressure without disrupting the economy.
Rock-bottom interest rates were necessary to spur growth during the recession, so could rising rates derail the recovery? The short answer is “no.” The long answer: If anything, interest rate normalization should prolong the current expansion. The economy has regained its momentum and should be able to continue growing without extraordinary support from the Fed. Businesses are optimistic enough to finance new operations and hire more employees, even as borrowing costs slowly begin to climb.
If interest rates are left too low in the current economic climate, imbalances will likely build, hastening the next recession. When borrowing costs are too low, the economy may begin to overheat as it grows in excess of its potential and inflationary pressure causes prices to spiral higher. And if capital is too inexpensive, asset bubbles are likely to form, creating imbalances that could destabilize the economy. The gradual process of interest rate normalization is necessary to encourage sustainable, long-term growth.
Interest rate normalization will be complete when the economy reaches full employment and inflation stabilizes at around 2 percent. The ideal level for interest rates is difficult to pinpoint in advance; in the past, the “normal” range for interest rates was generally accepted to be between 4 and 4.25 percent, but the slowing of the economy’s potential growth rate—due to demographic changes and an aging workforce—may be driving down the natural equilibrium level for interest rates.
The FOMC’s central tendency forecast currently calls for interest rates to rise to a long-term target between 2.75 and 3 percent, but the full range of members’ forecasts runs from 2.5 to 3.75 percent. Since the normalization process will be gradual—with each step dependent on growth and inflationary pressure—the true natural equilibrium rate should reveal itself over time.
Our reliance on a committee of economists to determine the timing of interest rate hikes may seem antiquated, which spurs the question: Is there not a calculation that could be used to balance borrowing costs against growth and inflation? An equation called the Taylor rule—first proposed by economist John B. Taylor—attempts to provide a mechanical solution to questions of interest rate policy: Interest rates should vary from their natural equilibrium by one-half of the level of excess unemployment and below-target inflation. (For more information on the Taylor rule and its impact, this research publication from the Federal Reserve Bank of Kansas City is a good start.)
The strict application of the Taylor rule could raise rates considerably from today’s levels. The official unemployment rate is within the target range for full employment and inflation is closing in on its target. Thus, interest rates should be very near their natural 4 percent equilibrium, or close to 3 percentage points above their present levels.
Application of the Taylor rule relies on several assumptions to the following questions: Is the natural equilibrium for interest rates really still 4 percent, or has it fallen due to demographic shifts? Is unemployment truly within the target range, or is there still considerable slack in the labor market?
Discouraged workforce dropouts and involuntary part-time employees are hidden from the headline unemployment rate, but they represent an untapped pool of workers who will have to return to full-time employment before the labor market truly tightens.
Given a different set of assumptions (e.g., a 3 percent natural equilibrium for interest rates, and a true unemployment rate 2 percent above full employment), the Taylor rule would recommend placing interest rates near 2 percent, only one point ahead of the Fed’s decision. And that figure still relies on debatable assumptions about the relationship between inflation and unemployment.
The Taylor rule is useful for thinking about the appropriate reaction to economic developments, but it’s limited as a tool for setting policy.
During the worst of the recession, near-zero interest rates failed to spur growth, and the Fed resorted to an unconventional “quantitative easing” program, which purchased bonds and other financial assets in an attempt to push capital into the private sector. The plan succeeded, but it left the Fed with $2 trillion in excess assets that will eventually need to be sold off.
As the Fed begins selling its assets, bond yields could rise abruptly. When Fed Chair Ben Bernanke first hinted in the spring of 2013 at a coming wind down of the Fed's large scale asset purchases, yields immediately climbed 100 basis points, well before the Fed eventually scaled back its purchases. A larger rise could result if markets were asked to absorb the Fed’s excess holdings today.
Fortunately, the Fed has complete control over the pace and timing of its balance sheet selloff. There is no imperative to push assets onto an unprepared market, and the Fed will likely be able to use its power over short-term interest rates to blunt any disruption caused by balance sheet normalization. Given the Fed’s extraordinary flexibility, the process of balance sheet normalization is likely to proceed in an orderly fashion.
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