Simply put, the Fed says they are worried about inflation. Inflation is the Fed’s broad metric for measuring the strength of the US economy. Too high of an inflation rate indicates an economy that may be over heating, leading to ever escalating price increases for goods and services and then, as a result, a recession. Too low of an inflation rate indicates an economy stuck in place where demand for goods and services is lackluster and potentially declining also leading to a recession. The Fed’s goal, they say, is to maintain a 2% inflation rate; a level the Fed believes permits the economy to experience good growth, but not over heat.
Right now inflation is low. And while the economy as measured by Gross Domestic Product (GDP) is growing, it’s growing only moderately. The unemployment rate is now at 5.0% (from Bureau of Labor Statistics – www.bls.gov/news.release/pdf/empsit.pdf, as of November 6, 2015), a level considered to be almost “full” employment and perhaps indicative of an economy ready to grow at higher rate. However, other measures of unemployment are much higher and the labor participation rate is at a 38 year low (from Bureau of Labor Statistics- data.bls.gov/pdq/SurveyOutputServlet, as of November 18, 2015). In addition, real wage growth is tepid or non-existent. Finally, the global economy is weak, tempering demand not only for US goods and services but for global goods and services as well. All in all, there is no strong indication of an economy ready to enter into a new, higher phase of growth.
So, back to the original question: Why in the world does the Fed want to raise rates?
As I said earlier, simply put, the Fed is worried about inflation. They are worried about inflation not because of the current state of the US economy but because of QE 1-3 and the possible expansion of the US economy. The combination worries the Fed because they believe US banks, and thus the economy, are highly leveraged because of the existence of large excess reserves. In my view, the Fed believes that when banks perceive the economy is growing reasonably strongly and the credit quality of loans has improved, they will accelerates loans, lending more than in previous similar situations. This, the Fed believes, will surely create inflation above 2%.
Is the Fed right? It is hard to know. What we do know, however, is that quantitative easing created large excess reserves in the banking system. Most people believed the Fed’s quantitative easing would flood the system with “money” through increased bank loans. That didn’t happen mainly because of 2 factors: 1) banks tightened their credit standards in the aftermath of the 2008 financial crisis and 2) the Fed for the first time ever started paying interest on reserves (both required and excess). The combination of these two factors created large excess reserves rather than more loans. When these factors no longer deter banks from making loans, the “leverage” in the banking system in the form of large excess reserves could very possibly increase inflation beyond what the Fed considers optimal.
What will be the impact of tightening if the Fed gets it wrong?
If the Fed tightens and economic growth remains moderate (for any number of reasons), the consequences will be minimal for 3 reasons:
- Once the Fed begins tightening, it will not blindly continue tightening. While “one and done” is a very real possibility, any further Fed tightening would be predicated on how the economy, employment and other important metrics have fared following the last tightening.
- Interest rates are at levels not seen since the 1950s. A 25 or 50bp increase in the Fed Funds rate (as well as the interest rate the Fed pays on reserves) is unlikely to significantly increase lending rates and affect the demand for money (ie, loans) and thus impair economic growth.
- If necessary, the Fed could loosen (ie, reverse tightening) by lowering the Fed Funds rate. Though not talked about, the Fed could also lower or eliminate the interest rate it pays on reserves, perhaps placing more pressure on banks to lend.
Overall though, the potential damage caused by tightening prematurely should be minimal. Given the stock market correction so far this year in anticipation of the Fed tightening, it’s quite possible the stock market would shake off such an event, maintain levels and enter a wait-and-see mode.