A Fed Rate Increase Still Fits the Data

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There is no hiding that the stock market has been hit hard through the end of 2018. As of December 21st, the tech heavy NASDAQ is in bear market territory, being down 20% since its recent high in August.

Investors have been completely gripped by fear of U.S.-China trade relations and a slowing global economy. Adding to this fear is anxiety over the Fed’s gradually increasing short term rates. At the end of December 19th, when the Fed funds rate was increased for a fourth time this year to a range of 2.25-2.50%, all major U.S. indexes ended the day in the red.

President Trump has also been a vocal critic of the rate hikes over the last few months, stating on Twitter prior to the Fed meeting that it is “incredible” that the Fed “is even considering another interest rate hike.”

So with rate hikes being the friend of neither the president nor investors these days, is the Fed’s policy really a threat to the U.S. economy? Let’s take a look.

The Funds Rate as an Instrument

The Fed as an institution has a dual mandate set by congress: to bring the economy to maximum employment and to maintain stable prices. To help reach these goals, the Fed adjusts its Fed funds rate based on the current conditions of the economy.

The funds rate is the over night rate depository institutions use to lend federal reserves to each other, and it is the basis for all other interest rates that they set. When the rate rises, borrowing costs also rise.

When the economy goes into a downturn, the Fed uses the funds rate as its primary monetary tool. After the 2007-2009 financial crisis, the Fed cut the rate to nearly 0.00% in order to stimulate borrowing and spending. This helps free up cash for companies, allowing them to spend money elsewhere, like on workers (remember full employment).

When the economy is doing well, the funds rate is used to keep it from over heating. As spending increases, inflation will be pushed up as demand puts pressure on prices. To maintain stable prices, the Fed increases the funds rate to push back spending and in turn, hold down prices.

The Economy Right Now

Is the economy in a place right now for the rate increases that have been happening throughout 2018? Most indicators point to yes.

A major reason for increasing the funds rate is the labor market and the 3.7% unemployment rate. This is well below the estimated 4.5% unemployment rate that the Fed characterizes as full employment.

At an unemployment rate below full employment, economists predict inflation to begin rising as spending by households increases. If the unemployment rate is well below the full employment mark, as it is now, then models predict inflation to have upward pressure.

The consumer price index, a widely used gauge of inflation, stands at 2.2% as of November 2018, right around the Fed’s 2% goal. With current prices fairly stable, it is easy to argue that the funds rate is counter intuitive.

However, with wage growth exceeding 3% for two consecutive months and lending to businesses still on the rise, prices may feel upward pressure going into 2019. There will be even greater pressure if the U.S.-China trade spat continues and tariffs result in a wide range of price increase. Increasing the funds rate now can help keep inflation right around 2% in the near future.

Overall, with such a strong labor market, the economy is likely going to maintain low unemployment and strong spending. With these positive numbers, the Fed has the data to back their decision to increase the funds rate.

As Always, Negatives

Even though economic data supports the current rate increases, there are also downsides to higher rates.

The cost of borrowing is a notable negative. With a near 0.00% funds rate for so long, many people have gotten used to cheap borrowing. With the steady increases over the course of 2018 though, costs are rising.

Credit cards’ variable rates are highly tied to the the prime rate, which is in turn tied to the funds rate. Credit cards are fairly susceptible to rate hikes as a result. With average credit card debt over $8,200 in the U.S., even a small increase of 0.25% to the funds rate can increase debt payments by $250 per year.

Auto loans are also a victim of a higher funds rate. The zero-interest loans that have been widely offered in recent years have begun to dry up, falling from 10.1% of all loans in 2017 to 5.6% in September 2018.

Moving Forward

With a higher funds rate, consumers and businesses are seeing borrowing costs increase. Many economists are also predicting a higher chance of a recession in 2019. Economists at Morgan Stanley give it a 15% chance. These support Jerome Powell’s plan on slowing rate growth in 2019 and moving to a more wait-and-see approach as the funds rate moves into a neutral position.

Current data supports the decision to raise rates in December, though. Even with highly visible stock market fluctuations and President Trump’s public complaints, the economy is still at a point where a rate increase has more benefits than negatives. After reviewing the data, the public should ignore the noise and keep their confidence in the Fed’s decisions.

 

 

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