The US Federal Reserve Proceeds with Caution Toward Rate Hikes

Rarely has a monetary decision been so anticipated. After months of delays, the Federal Reserve finally raised rates by a quarter of a point on Wednesday, Dec. 16. Although this was the first fiscal tightening the U.S. has seen for nine and a half years, the central bank’s movement is not really a surprise. Its chair, Janet Yellen, having mentally prepared the public for a long time, could hardly delay the rise without risking a taint to the Fed’s credibility.

Indeed, after injecting $2.5 trillion into the U.S. economy to restore it after the financial crisis, and after having maintained, for seven years, its zero interest rate, the central bank believes that its goals — the return to full employment and inflation of 2 percent – are on course. “We feel the conditions that we set out for a move [of the rates]…had been satisfied,” explained Ms. Yellen during a press conference, adding that continuing to keep rates at zero would lead to “less scope to respond to negative [economic] shocks.”

However, the movement must take measured steps. In its statement, the Fed evoked a “gradual” rise in rates, which are “likely to remain, for some time, below levels that are expected to prevail in the longer run.” The rates will oscillate within a range of 0.25 percent to 0.5 percent and should continue to rise at the rate of one percentage point per year, which should result in a level of 3.3 percent by 2019.

‘The Fed Remains Cautious’

This extreme caution in the pace of the tightening has allowed the Fed’s monetary policy committee to reach a unanimous decision. Ms. Yellen also urged that the significance of this first rate hike should not be “overestimated,” noting that U.S. monetary policy would remain globally accommodative.

“We feel that the Fed remains cautious, although it should have raised rates earlier in the year to the extent that the economic indicators were already satisfactory,” states Georges Ugeux, who teaches a course on central banks at Columbia University in New York. “Today, the Fed is simply going with the flow on rates, and that’s not necessarily a compliment.”*

That said, the path the Fed is taking remains narrow. “The Fed is going out of its way to assure markets that, by embarking on a ‘gradual’ path, this will not be your traditional interest rate cycle,” commented Mohamed El-Erian, chief economist at Allianz, referring to the rapid rate increase that prevailed under Alan Greenspan’s chairmanship. The message seems to have been received loud and clear: Wall Street closed on a decidedly positive note, with the Dow Jones up 1.27 percent and the Nasdaq up 1.52 percent. On the foreign exchange market, the dollar was expected to be boosted by higher U.S. rates, but only marginally rose against the euro and the yen, as traders obviously had anticipated that tightening would be gradual.

But if the Fed acted carefully, it is mainly because the situation it faces remains unpredictable. Despite Ms. Yellen’s reassuring words on Wednesday about the strength of U.S. growth and an unemployment rate of 5 percent, the alignment of the planets is far from perfect. Thus, “inflation has been persistently falling short of the Fed’s target,” states Andrew Levin, an economics professor at Dartmouth College in New Hampshire and former special adviser to Ben Bernanke, Ms. Yellen’s predecessor.

Why Act Now?

The Fed’s preferred indicator in this area, the consumer price index, reached 1.3 percent, notably excluding food and energy. According to expectations that the Fed released on Wednesday, the 2 percent target will be achieved in 2018 … As for wage increases, they remain lacking. “We’ll have to rewrite the macroeconomics books,” quips Mr. Ugeux. “For five years we’ve said that inflation will recover, and it hasn’t recovered. I think prices are now much more influenced by spending power than by interest rates. It is time to look more at the real economy and at what businesses are doing.”*

Thus, faced with still-hypothetical inflationary pressures, why act now on rates? Ms. Yellen reasoned by explaining that intervening too late would raise prices, which would require “an abrupt tightening” that “could increase the risk of pushing the economy into recession.”

But some believe that this rate hike is already too late since the recovery cycle threatens to come to an end. Indeed, it started 78 months ago, an exceptionally long time relative to the duration of previous periods. Besides, signs of a slowdown are already beginning to appear. Among them are the decline in industrial production for three consecutive months, the downturn in production capacity utilization rates since the beginning of the year, and finally, company profits, which are generally on a downward trend. As for the unemployment rate, we know that it reflects only a part of the reality of the labor market, given that tens of millions of unemployed Americans do not appear in the statistics.

But the Fed cannot take the risk of waiting until all the lights turn green to act, preferring instead to make a decision that remains mostly symbolic. “The immediate macroeconomic effect will be insignificant,”* anticipates Mr. Ugeux. As Ms. Yellen emphasizes, “Loans that are linked to longer-term interest rates are unlikely to move … very much,” and the goal of this first increase was above all to reflect “confidence that the economy will continue to strengthen.” The central bank thus expects growth of 2.4 percent in 2016, 0.3 points better than this year, before a slight deceleration in 2017 with a GDP growth of only 2.2 percent. It is often said that it is the first step that counts. But with the rate hikes, the worst is probably yet to come.

*Editor’s note: The original quotation, accurately translated, could not be verified.