Three issues surround the debate over the Fed and raising interest rates: why should interest rates be increased? When should they be raised and how can the Fed do it. All three need to be resolved.
The traditional description of Fed policy is “removing the punchbowl when the party gets good.” The Fed’s dual mandate of employment and stable prices is a balancing act between competing goals. With the economy growing, employment rising and unemployment under 6%, attention is shifting to prices. With a more upbeat economy comes expectations of higher inflation and upward pressure on prices and wages. Inflation depends on how aggressively business tries to raise prices. The objective in raising interest rates is lower expectations of future inflation to limit efforts to raise prices. Neither the size nor the growth of the money supply completely determines inflation rates. Those who believe that the money supply is the only factor behind inflation must explain why inflation is currently so low after five years of unusually high money supply growth.
The Fed funds rate affects the economy and financial markets, not just inflation expectations. The Fed’s three rounds of large scale asset purchases – popularly known as QE or quantitative easing – pushed the Fed funds rate to almost zero (see chart) and were a crucial factor in the economic recovery. QE worked by keeping interest rates artificially low and boosting prices of stocks, homes and other assets. However, zero interest rates distort prices and returns in financial markets. With the economy doing better, the Fed wants to normalize interest rates and move the fed funds rate from almost zero to something a bit higher.
A “normal” level for the Fed funds rate depends on inflation, employment and the economy. One widely followed definition of a normal Fed funds rate is the Taylor rule based on analysis of Fed rate setting by John Taylor, a Stanford University economist. The chart, based on calculations of the Taylor rule by the St Louis Federal Reserve Bank, compares the rule to the past and current Fed funds rate, suggesting the the Fed funds rate should be raised. However, the central bank is not in a rush, will probably take small steps of a quarter percentage point at a time.